Solution Manual For Global Financial Accounting and Reporting, 5th Edition by Walter Aerts, Peter Wa

Solutions to end-of-chapter assignments

3.1 Solution - Jennifer’s canoes Prerequisites: Chapter 3 + concept of amortisation/depreciation of non-current assets

Assets Cash Canoes Concession Total Financing Liabilities - Short-term - Long-term Equity Share capital Profit or loss Sales Amortisation concession Annual rental Depreciation canoes Total

(a)

(b)

(c)

(d)

(e)

Year end

+60,000

-50,000

-10,000 +30,000

+90,000

+60,000

+50,000 0

+20,000

+90,000

-10,000 -6,000 -10,000 -26,000

80,000 24,000 40,000 +144,000

+20,000

20,000 40,000

+40,000 +20,000

20,000 64,000 +90,000

+60,000

Statement of profit or loss (Income statement) Sales Expenses Concession - rental Concession - amortisation Canoe depreciation Profit

Statement of financial position (Balance sheet) Intangible fixed assets Concession Less amortisation Tangible fixed assets Canoes Less depreciation Cash Total Equity Share capital Profit for the year Liabilities - Long-term - Short-term Total

0

+20,000

+90,000

-10,000 -10,000 -6,000 -26,000

+144,000

90,000 10,000 10,000 6,000

50,000 -10,000 30,000 -6,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-26,000 64,000

40,000

24,000 80,000 144,000 20,000 64,000 40,000 20,000 144,000

You may wish to comment on the operating items which are missing in this assignment (e.g., salaries, interest expense, income taxes) and which would significantly affect the current profitability of the business.

3.2 Solution – James / Selling computers

Year 1 Sales Cost of computers sold Rent Lease amortisation Profit

45,000 30,000 6,000 2,500

Year 2 Sales Cost of computers sold Rent Lease amortisation Loss

-38,500 6,500

1,000 20,000 6,000 2,500

-28,500 -27,500

Lifetime result for the business

-21,000

3.3 Solution - A&S retail shop (1) Start

April April April April April Rent Purchase Advertising Sales Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

30,000 30,000

-700 -700

6,300 -6,300 0

-1,000 -1,000

-3,150 4,900 1,750

0 0 0 3,150 -1,200 25,700 -1,200 28,850

Financing Liabilities Long-term Short-term

4,000 2,000

4,000 2,000

Equity Share capital

24,000

24,000

Profit & Loss Sales Monthly rent Depreciation Advertising Salaries Interest Cost of goods sold

4,900 -700 -1,000 -1,200 -3,150

4,900 -700 0 -1,000 -1,200 0 -3,150

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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Total

30,000

-700

0

-1,000

1,750

-1,200 28,850

3.3 Solution - A&S retail shop (2)

Start

May May May May Rent Purchase Sales Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

0 0 0 3,150 25,700 -700 28,850 -700

5,000 -3,500 -5,000 5,400 0 1,900

0 0 0 4,650 -1,200 24,200 -1,200 28,850

Financing Liabilities Long-term Short-term

4,000 2,000

4,000 2,000

Equity Share capital

24,000

24,000

Profit & Loss Sales 4,900 Monthly rent -700 -700 Depreciation 0 Advertising -1,000 Salaries -1,200 Interest Cost of goods sold -3,150 Total 28,850 -700

5,400

0

-3,500 1,900

10,300 -1,400 0 -1,000 -1,200 -2,400 0 -6,650 -1,200 28,850

3.3 Solution - A&S retail shop (3)

Start

June June June June June Rent Carts Sales Purchase Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

0 0 0 4,650 24,200 28,850

1,200 -700 -700 1,200

-2,900 4,500 1,600

4,650 -4,650 0

0 0 1,200 6,400 -1,200 22,150 -1,200 29,750

Financing Liabilities Long-term

4,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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4,000

Short-term

2,000

Equity Share capital

24,000

Profit & Loss Sales Monthly rent Depreciation Advertising Salaries Interest Cost of goods sold Total

10,300 -1,400 0 -1,000 -2,400 -6,650 28,850

1,200

3,200

24,000

4,500 -700

-2,900 -700 1,200 1,600

0

14,800 -2,100 0 -1,000 -1,200 -3,600 0 -9,550 -1,200 29,750

3.3 Solution - A&S retail shop (4)

Start

July July Rent Sales

July Carts

July Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

0 0 1,200 6,400 -4,500 22,150 -700 7,200 -1,200 29,750 -700 2,700 -1,200

-1,200 -1,200

0 0 1,200 1,900 26,250 29,350

Financing Liabilities Long-term Short-term

4,000 3,200

Equity Share capital

24,000

-1,200

Profit & Loss Sales 14,800 7,200 Monthly rent -2,100 -700 Depreciation 0 Advertising -1,000 Salaries -3,600 Interest Cost of goods sold -9,550 -4,500 Total 29,750 -700 2,700 -1,200

4,000 2,000

24,000

22,000 -2,800 0 -1,000 -1,200 -4,800 0 -14,050 -1,200 29,350

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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3.3 Solution - A&S retail shop (5)

Start

August August August August August Rent Purchase Motor van Sales Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

0 0 1,200 1,900 26,250 29,350

15,000

-700 -700

4,800 -4,800 0

-12,000 3,000

-3,800 5,800 2,000

-1,200 -1,200

15,000 0 1,200 2,900 13,350 32,450

Financing Liabilities Long-term Short-term

4,000 2,000

Equity Share capital

24,000

Profit & Loss Sales 22,000 Monthly rent -2,800 Depreciation 0 Advertising -1,000 Salaries -4,800 Interest Cost of goods sold -14,050 Total 29,350

4,000 5,000

3,000

24,000

5,800 -700

-700

0

3,000

-3,800 2,000

27,800 -3,500 0 -1,000 -1,200 -6,000 0 -17,850 -1,200 32,450

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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3.3 Solution - A&S retail shop (6)

Start

September September September September September September Rent Purchase Sales Sales Loan Salaries

Total

Assets Motor van Computer Shopping carts Inventory Cash Total

15000 0 1200 2900 13350 32450

6,500 -6,500 0

-700 -700

-3,500 5,000 1,500

-750 1,200 450

-1,180 -1,180

-1,200 -1,200

15,000 0 1,200 5,150 9,970 31,320

Financing Liabilities Long-term Short-term

4000 5000

Equity Share capital

24000

4,000 4,000

-1,000

24,000

Profit & Loss Sales 27800 Monthly rent -3500 Depreciation 0 Advertising -1000 Salaries -6000 Interest Cost of goods sold -17850 Total 32450

5,000

1,200

-3,500 1,500

-750 450

34,000 -4,200 0 -1,000 -1,200 -7,200 -180 -22,100 -1,200 31,320

-700

-180 -700

0

-1,180

3.3 Solution - A&S retail shop (7)

Start

October

October

October

October

October

Rent

Sales

Sales

Purchase

Salaries

Total

Assets Motor van

15,000

15,000

Computer

0

0

Shopping carts

1,200

1,200

Inventory

5,150

Cash

9,970

Total

31,320

-2,000

-750

1,250

3,650

-700

3,400

1,200

-1,250

-1,200

11,420

-700

1,400

450

0

-1,200

31,270

Financing Liabilities Long-term

4,000

4,000

Short-term

4,000

4,000

Equity For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

Share capital

24,000

24,000

Profit & Loss Sales

34,000

Monthly rent

-4,200

Depreciation

0

0

Advertising

-1,000

-1,000

Salaries

-7,200

Interest

3,400

1,200

38,600

-700

-4,900

-1,200

-8,400

-180

Cost of goods sold

-22,100

Total

31,320

-180

-700

-2,000

-750

1,400

450

-24,850 0

-1,200

31,270

3.3 Solution - A&S retail shop (8)

Start

November

November

November

Rent

Sales

Salaries

Total

Assets Motor van

15,000

15,000

Computer

0

0

Shopping carts

1,200

1,200

Inventory

3,650

Cash

11,420

-700

2,600

-1,200

12,120

Total

31,270

-700

200

-1,200

29,570

-2,400

1,250

Financing Liabilities Long-term

4,000

4,000

Short-term

4,000

4,000

24,000

24,000

Equity Share capital

Profit & Loss Sales

38,600

Monthly rent

-4,900

Depreciation

0

0

Advertising

-1,000

-1,000

Salaries

-8,400

Interest

-180

Cost of goods sold

-24,850

Total

31,270

2,600

41,200

-700

-5,600

-1,200

-9,600 -180

-2,400 -700

200

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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-27,250 -1,200

29,570

3.3 Solution - A&S retail shop (9)

Start

December

December

December

December

December

Rent

Purchase

Sales

Sales

Salaries

Total

Assets Motor van

15,000

15,000

Computer

0

0

Shopping carts

1,200

Inventory Cash

1,250 12,120

Total

29,570

1,200 -700

8,075 -8,075

-6,500 9,900

-1,800 3,200

-1,500

1,025 14,945

-700

0

3,400

1,400

-1,500

32,170

Financing Liabilities Long-term

4,000

4,000

Short-term

4,000

4,000

24,000

24,000

Equity Share capital Profit & Loss Sales

41,200

Monthly rent

-5,600

Depreciation

0

Advertising

-1,000

Salaries

-9,600

Interest

9,900

3,200

54,300

-700

-6,300 0 -1,000 -1,500

-180

Cost of goods sold

-27,250

Total

29,570

-11,100 -180

-700

0

-6,500

-1,800

3,400

1,400

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-35,550 -1,500

32,170

3.3 Solution - A&S retail shop (10) Start

January

January

January

January

January

Rent

Bonus

Purchase

Sales

Salaries

Total

Assets Motor van

15,000

15,000

Computer

0

0

Shopping carts

1,200

1,200

Inventory

1,025

Cash

14,945

-700

Total

32,170

-700

4,000

-3,700

1,325

-600

-4,000

6,300

-1,200

14,745

-600

0

2,600

-1,200

32,270

Financing Liabilities Long-term

4,000

4,000

Short-term

4,000

4,000

24,000

24,000

Equity Share capital

Profit & Loss Sales

54,300

Monthly rent

-6,300

Depreciation

0

0

Advertising

-1,000

-1,000

Salaries

-11,100

Interest

-180

Cost of goods sold

-35,550

Total

32,170

6,300

60,600

-700

-7,000

-600

-1,200

-12,900 -180

-3,700 -700

-600

0

February

February

February

Rent

computer

Purchase

-39,250

2,600

-1,200

32,270

February

February

February

Total

Sales

Sales

Salaries

3.3 Solution - A&S retail shop (11).

Start Assets Motor van

15,000

Computer

0

15,000 1,350

Shopping carts

1,200

Inventory

1,325

Cash

14,745

-700

Total

32,270

-700

1,350 1,200 5,000

-4,500

-850

-1,350

-5,000

7,850

1,500

-1,200

15,845

0

0

3,350

650

-1,200

34,370

Financing

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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975

Liabilities Long-term

4,000

4,000

Short-term

4,000

4,000

24,000

24,000

Equity Share capital Profit & Loss Sales

60,600

Monthly rent

-7,000

Depreciation

0

7,850

1,500

69,950

-700

-7,700 0

Advertising

-1,000

-1,000

Salaries

-12,900

-1,200 -14,100

Interest

-180

Cost of goods sold

-39,250

Total

32,270

-180 -700

0

0

-4,500

-850

3,350

650

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-44,600 -1,200

34,370

3.3 Solution - A&S retail shop (12)

Start

March

March

March

March

March

March

Rent

Purchase

Sales

Depreciation

Loan

Salaries

Total

Assets Motor van

15,000

-2,000

13,000

Computer

1,350

-75

1,275

Shopping carts

1,200

-200

1,000

Inventory

975

5,000

-4,600

Cash

15,845

-700

-5,000

7,900

Total

34,370

-700

0

3,300

1,375

-2,275

-1,150

-1,700

15,195

-1,150

-1,700

31,845

Financing Liabilities Long-term

4,000

Short-term

4,000

4,000 -1,000

3,000

Equity Share capital

24,000

24,000

Profit & Loss Sales

69,950

Monthly rent

-7,700

Depreciation

0

Advertising

-1,000

Salaries

-14,100

Interest

-180

Cost of goods sold

7,900 -700

-8,400 -2,275

-2,275 -1,000 -1,700 -150

-44,600 34,370

77,850

-330

-4,600 -700

0

3,300

-15,800

-49,200 -2,275

-1,150

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-1,700

31,845

3.3 Solution - A&S retail shop (13) Statement of profit or loss (April 1 20X1 - March 31 20X2) Sales

77,850

Expenses Monthly rent

-8,400

Depreciation

-2,275

Advertising

-1,000

Salaries

-15,800

Interest

-330

Cost of goods sold

-49,200 -77,005

Profit

845

Statement of financial position (at 31 March 20X2) Assets Non-current assets Motor van

13,000

Computer

1,275

Shopping carts

1,000

Current assets Inventory

1,375

Cash

15,195

Total

31,845

Financing Equity Share capital

24,000

Profit for the period

845

Liabilities Long-term liabilities

4,000

Short-term liabilities

3,000

Total

31,845

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

3.4 Solution- George and Val / Decorators (1)

Prerequisites: Specifics on revenue recognition (Work-in-process, % of completion method) + Prepayments as liabilities

Month 1

Assets Cash Receivables Work-inprocess Motor van Totals Financing Liabilities Payables Prepayments Equity Share capital

Start

(a)

+2,000

+300

+2,000 +4,000

+300

(b)

(c)

+125

+100 +200 -125

+270

-270 +1,230*

+125

+175

+270

-40

+125 +300

(e)

End

-1,000

1,400 200 1,230

+270

395

+4,000

4,000 +600 -125

+4,000

2,000 4,830

-300

Profit

Totals

(d)

+300

+125

+175

+270

+1,230 -270 -1,000 -40

435

4,830

* The intention is that the 270 of materials mentioned in (d) relate to the 1,200 order. This is confirmed in note (f). The work in progress figure of 1,230 is made up of 270 materials plus (0.8*1,200). The assignment specifies at (e) that 80% of the work had been done, so we take 80% of the turnover to work-in-process. We have chosen also to expense 100% of the materials, but 80% is also an acceptable answer, giving a work-in-process of 1,176, and expensing 216 of materials in profit and loss.

Statement of profit or loss (month 1) Sales Materials used Salaries Profit

1,830 395 1,000

Statement of financial position (as at end month 1) Motor van 2,000 Share capital Work-to-date 1,230 Profit-to-date Receivables 200 Trade payables Cash at bank 1,400 Total 4,830 Total

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-1,395 435

4,000 435 395 4,830

Solution- George and Val / Decorators (2)

Month 2

Start

(f)

(g,h)

I

(k)

(j,l,m)

End

Assets Cash

1,400

+1,470

+500

-395

+600

2,485

200 1,230

-1,230

+80 -80

+180

+380 -180

-90 -1,000 -200

2,000 4,830

+240

+500

-215

+800

-1,290

4,865

+80

-395 +180

Receivables Work-inprocess Motor van Totals Financing Liabilities Payables

395

Equity Share capital

4,000

380

260

4,000

Profit

435

+240

+500 -80

Totals

4,830

+240

+500

+980 -180 -215

Statement of profit or loss (month 2) Sales Materials used Salaries External services Bad debt expense Profit

+800

-90 -200 -1,000 -1,290

605

4,865

1,720 260 1,000 90 200

Statement of financial position (as at end month 2) Motor Van 2,000 Share capital Receivables 380 Profit-to-date (m1+m2) Cash at bank 2,485 Trade payables Total 4,865 Total

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-1,550 170

4,000 605 260 4,865

4.1 Solution – Revenue recognition (1)

(a) Freelance journalist As the article was written in 20X1, there is a prima facie case for the revenue being treated as income for 20X1. However, publishers usually regard articles as being definitively accepted only when published (transfer of copyrights) and there is therefore a case for saying that delivery (satisfaction of the performance obligation) only took place in effect in February 20X2, and consequently the revenue should be treated as arising in 20X2.

If the financial statements are used as a basis for taxation of income, Carolyn will have a tax incentive to show the income as being earned in 20X2 because this will defer payment of tax for a year.

(b) Beker Industries A sale of goods is often made subject to satisfactory installation. If the installation is essential to the functionality of the delivered goods, revenue should only be recognized when installation (and inspection) is complete. If the installation process is simple in nature, immediate recognition of revenue upon the buyer‟s acceptance of delivery is permitted (for example, the installation of a factory-tested television receiver which only requires unpacking and connection of power).

Beker Industries should recognize revenue when the installation is complete. The installation is critical to customer acceptance and payment from the network operator. 

Revenue to be recognized on 5 January 20X6

(c) Standard International Sales of gift certificates will not be recognized as revenue as there has been no real performance yet on the part of the bookshop (supplying a book to the customer). The certificates not yet redeemed at the end of the month will be recognized as “unearned revenue”. Unearned revenue (deferred revenue) is a liability where the future sacrifice of economic benefits refers to the future delivery of books out of the current inventory (outflow of assets).

Unearned revenue (deferred revenue) is a liability where the future transfer of economic resources refers to the future delivery of books out of the current inventory (outflow of assets).  Cash (A+) + Deferred Revenue (L+)  Deferred Revenue (L-) + Revenue (E+) The bookshop has definitively a cash incentive to use gift certificates, as the prepayment would finance part of its inventory.

Note that revenue may be taken (proportionally to exercised rights) for the value of the gift certificates which are expected not to be redeemed! This is called „Breakage‟ and stands for expected unused rights.

(d) Merseyside Shipbuilding When such a contract is signed, the company knows the customer and the contract price. Assuming future costs can be estimated, it can determine, with reasonable accuracy, the

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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4.1 Solution – Revenue recognition (2) profits earned at each stage of the contract. Thus, it can recognize revenue and profit on a pro rata basis over the contract‟s life. This is in accordance with the „percentage-of-completion‟ method of ® IFRS 15 Revenue from Contracts with Customers.

The scheduling of receipts from the client appears in this case to have only a loose connection with the advancement of the work and can be ignored for the purposes of measuring revenue.

At the extreme, two sets of accounting rules are possible: (i) recognition of sales each year proportional to the work done (giving precedence to the matching principle); and (ii) recognition of the full value of the contract at completion (giving precedence to the prudence principle). Following (i) in this case, the shipbuilder would probably recognize 20% of revenue in 20X2. In 20X3, the shipbuilder would recognize 50% of the €4m sales price (€2,000,000) and in 20X4 the remaining €800,000 when the ship was delivered. In both cases, the company should consider the likelihood of finishing the contract within the planned cost limits, and the likelihood of the customer negotiating a reduced price because of any faults in the execution of the contract.

Method (i) gives users a better idea of the real economic activity of the company year on year, but method (ii) recognizes that there is uncertainty until the final product has been accepted by the client and is helpful for tax purposes because no profit is recognized until 20X4.

Note that for method (i) it would be important to check what the contract specifies when the customer decides to terminate the contract. If Merseyside Shipbuilding would only be entitled to retain any progress payments received from the customer without further compensation, there would be a problem. Even though the payments made by the customer are non-refundable, the cumulative amount of those payments is not expected, at all times throughout the contract, to at least correspond to the amount that would be necessary to compensate the entity for performance completed to date. In that case, IFRS 15 Revenue from Contracts with Customers would not allow revenue recognition over time.

(e) PrintCo The contract relates to a combined agreement including 10 laser printers and maintenance cover for two years. The contract thus includes two separate performance obligations with different timing of performance. Total revenue has to be apportioned between the performance obligations and then recognized as the individual services are provided.

The normal selling prices are: Supply of 10 printers Supply of maintenance in Year 1 Supply of maintenance in Year 2 Total services provided Combined price

€60,000 €10,000 €10,000 €80,000 €72,000

This means that PrintCo is selling at 72,000/80,000 or 90% of the normal price i.e. 10% below normal selling price.

Each component part of the contract is reduced by 10% as follows: Supply of 10 printers 60,000 x .90 Supply of maintenance in Year 1 10,000 x .90 Supply of maintenance in Year 2 10,000 x .90 Combined price

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

€54,000 €9,000 €9,000 €72,000

4.1 Solution – Revenue recognition (3)

This process represents Step 4 of the revenue recognition model of IFRS 15 Revenue from Contracts with Customers: the allocation of the transaction price of the contract to the separate performance obligations in the contract.

The accounting entries for a contract under IFRS 15 Revenue from Contracts with Customers would be:

-

At 1 July 20X1:

Dr Trade receivables (+ A) €72,000 Cr Revenue (equipment sales) (+ E) €54,000 Cr Deferred revenue (Liability) (+ L) €18,000 Recording revenue of the printer sale on delivery date and the maintenance package as deferred revenue Dr Cost of goods sold (equipment) (- E) Cr Inventory (- A) Recording expenses of providing inventory items (printer}

-

€30,000 €30,000

At year-end 20X1 (or at a monthly rate):

Dr Deferred revenue (Liability) (- L) €4,500 Cr Revenue (maintenance) (+ E) €4,500 Recording revenue for the maintenance (stand-by) performance and transfer of deferred income Dr Cost of goods sold (maintenance) (- E) €2,500 Cr Bank (- A) Recording the outlays for wages and materials used for maintenance

-

€2,500

At year-end 20X2:

Dr Deferred revenue (Liability) (- L) €9,000 Cr Revenue (maintenance) (+ E) €9,000 Recording revenue for the maintenance (stand-by) performance and transfer of deferred income Dr Cost of goods sold (maintenance) (- E) €5,000 Cr Bank (- A) Recording the outlays for wages and materials used for maintenance

-

€5,000

Year 20X3 (until 30 June 20X3):

Dr Deferred revenue (Liability) (- L) €4,500 Cr Revenue (maintenance) (+ E) €4,500 Recording revenue for the maintenance (stand-by) performance and final transfer of deferred income Dr Cost of goods sold (maintenance) (- E) €2,500 Cr Bank (– A) Recording the outlays for wages and materials used for maintenance

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

€2,500

4.1 Solution – Revenue recognition (4)

Financing component (advanced issue) On a more advanced note, it could be argued that the customer is prepaying the service contract, particularly for the second year. Hence, PrintCo should recognize the payment of interest to the customer and then offset that by recognizing a higher service fee to cover the contract amount and to recover the imputed interest. There is a clause which allows items of one year or less to be ignored (IFRS 15/ par.63).

Thus, if the relevant interest rate was 5% and the financing was deemed applicable to prepayment of the maintenance for the second year to be 1 ½ years to the middle of the second year, then the interest deemed payable would be 5% of €9,000 or €450 in year 1 and €236.25 in the second contract year 2, calculated as 5% of €9,450 for half a year.

The total revenue for the maintenance for the 2-year period would become €9,000 + €9,686.25 = €18,986.25 with corresponding interest expense of €986.25.

(f) Wirral Electrical - Any manufacturer faces this situation - at year-end it is always possible that goods invoiced to customers may be returned.

If sales are made with a general right of return, it would be considered a customer contract with variable consideration. In that case, the manufacturer should estimate the likelihood of returns based on previous years‟ experience and decrease the transaction price accordingly. This would mean that Wirral‟s 20X1 revenue would be less than the amount invoiced.

However, if sales are made with a customary product warranty, the situation would be somewhat different when the product warranty causes the returns. If sales are made with a product warranty, a provision for product warranty should be made at the point of sale for the expected cost of product defect returns. Later, the effective cost of replacements, repairs or reimbursements should be covered by that provision (with no effect on profit or loss when the provision is used). Product warranty provisions would not affect the amount of revenue recognized at the point of sale.

A customary product warranty is a kind of quality guarantee: a guarantee that the product meets agreed-upon specifications in the contract at the time the product is sold and will operate as promised during a specified period. Such an assurance-type warranty is presumed to be included in the selling price of the product. It would not be treated as a separate performance obligation as it flows from a legal requirement without any managerial discretion.

Service-type warranties, however, provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service, because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity shall account for the promised warranty as a performance obligation and allocate a portion of the transaction price to that performance obligation. The longer the coverage period, the more likely it is that the promised warranty is a performance obligation, because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.2 Solution –Review of revenue-related transactions (1)

- After-sales service commitments IFRS 15 Revenue from Contracts with Customers would require that a portion of the total revenue receivable under the contract is deferred for the after-sales service commitments. In fact, the contract is a multiple-element contract. It covers two separate performance obligations: the supply of its products (goods) and the supply of after-sales services. The transaction price of €30m should be allocated to these two performance obligations according to their relative stand-alone selling prices. If these stand-alone prices are not available, they should be estimated. The stand-alone selling price for the products is €25m. The stand-alone selling price of the services component has to be estimated (using a cost-plus approach).

The total expected costs of the servicing for the contract are €4m (2 years) and, at a margin of 20%, this equates to a revenue figure of €5m (4 x 100/80). So, in fact, the combined contract includes no discount.

The goods are taken in revenue at the time of delivery in 20X8, while the services revenue (as a stand-ready performance obligation) is recognized as revenue over time. The amount initially deferred for the services should cover the expected costs to be incurred by Borlo AG plus a reasonable profit allowance on the servicing.

Since six months of the service period has elapsed, 6/24 of the services revenue figure (€1.25m) is recognized in the current period (20X8). Therefore, €3.75m is deferred and included as deferred revenue. €2.5m of the deferred revenue is included as a current liability and the balance of €1.25m as a non-current liability.

- Sales with right of return IFRS 15 Revenue from Contracts with Customers requires that when goods are supplied on a sale or return basis, the contract needs to be treated as a variable consideration contract.

Therefore, the total amount recognized as revenue (10 x 100/80 = €12.5m) should be decreased by 5 per cent to adjust for the „expected‟ transaction price which would be €12.5m less 5 per cent expected returns. Moreover, the cost of the goods sold (€10m) should also be adjusted and the corresponding amount of €0,625m added back to inventory and taken off cost of sales.

-

Bundled services

If connection and activation is considered a separate performance obligation, Teleservices would apply the relative stand-alone selling price method as follows:

Connection fee Access fee Troubleshooting Total

Selling price of each component if sold separately 5,000 12,000 23,000 40,000

Allocation to total consideration

Allocated amount

5,000/40,000 x 35,000 12,000/40,000 x 35,000 23,000/40,000 x 35,000

4,375 10,500 20,125 35,000

At inception of the agreement (1/12/20X8): DR Cash (A+) CR Revenue – connection fee (E+) CR Deferred revenue – access (L+) CR Deferred revenue – troubleshooting (L+)

35,000 4,375 10,500 20,125

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.2 Solution –Review of revenue-related transactions (2)

The deferred revenue for each of the undelivered elements (i.e. the ongoing access and on-call troubleshooting) will be recognized when those services are delivered. Because these are available to the customer continuously over the period of the agreement, the revenue should be recognized on a straight-line basis over time.

At end Year 1 (31/12/20X8): DR Deferred revenue – access (L-) DR Deferred revenue – troubleshooting (L -) CR Revenue (E+)

875 1,677 2,552

At end Year 2 (31/12/20X9): DR Deferred revenue – access (L-) DR Deferred revenue – troubleshooting (L-) CR Revenue (E+)

9,625 18,448 28,073

There may, however, be good grounds to argue that the connection fee and the activation fee (a non-refundable upfront fee) do not qualify as a separate performance obligation (as it would not result in a transfer of a promised good or service to the customer). Instead, the upfront fee could be seen as an advance payment for future services, and therefore, would be recognized as revenue when those future services are provided. The revenue recognition period may even extend beyond the initial contractual period if the company grants the customer the option to renew the contract without having to pay a new activation fee (IFRS 15/ par. B49).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.3 Solution – Wirral Electrical – Credit transactions

Opening

Sales

Third parties

Other

End 31/12/20X2

Assets Cash

1,500

+8,500

+13,250 -17,500

-3,000

2,750

Inventories Trade receivables Total

400 2,500 4,400

+200 +14,000 +22,500

-13,250 -17,500

600 3,250 6,600

Financing Payables

3,200

Equity (Share capital) Profit

1,200

Total

4,400

+2,800

-17,500 +18,400

4,100 1,200

+8,500 +14,000 +22,500

-18,400 -17,500

-3,000 +200 -2,800

1,300 6,600

Statement of profit or loss for 20X2 Sales Expenses Cost of goods sold Overheads Profit

22,500 18,200 3,000

-21,200 1,300

Statement of financial position at 31/12/20X2 Inventories Trade receivables Cash

600 3,250 2,750

Share capital Profit Payables

1,200 1,300 4,100

Total

6,600

Total

6,600

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.4 Solution – Lowhill Gravel Company – Inventory measurement

a. (1) FIFO: Inventory:

300 tons @ 10 = 3,000 250 tons @ 9 = 2,250 50 tons @ 8 =

400 5,650

(2) LIFO: Inventory:

500 tons @ 7 = 3,500 100 tons @ 8 =

800 4,300

(3) Weighted average: Weighted average cost per ton =

(500  7)  (1,000  8)  (250  9)  (300  10) 2,050 =

3,500  8,000  2,250  3,000  8.17 2,050

Inventory = 600 tons @ 8.17 = 4,902

b. (1) FIFO: Gross profit?

Sales Cost of goods sold Gross profit

18,000 (500 x 7) + (950 x 8) = 11,100 6,900

(2) LIFO: Gross profit?

Sales Cost of goods sold

18,000 (300 x 10) + (250 x 9) + (900 x 8) = 12,450

Gross profit

5,550

(3) Weighted average: Gross profit?

Sales Cost of goods sold Gross profit

18,000 1,450 x 8.17 = 11,846.50 6,153.50

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.5 Solution - Mansfield Supply Co. Ltd – Inventory measurement

Statements of profit or loss 20X1

20X2

20X3

Sales

120,000

150,000

110,000

Opening inventory Purchases Closing inventory Cost of goods sold

68,000 7,400 60,600

7,400 82,900 9,800 80,500

9,800 63,400 6,900 66,300

Gross margin

59,400

69,500

43,700

Other expenses Net profit/(loss)

59,100 300

64,800 4,700

44,800 (1,100)

31/12/20X1

31/12/20X2

31/12/20X3

Non-current assets (net) Inventory Cash Total

36,000 7,400 2,700 46,100

32,000 9,800 10,900 52,700

28,000 6,900 13,300 48,200

Equity Share capital Retained profit

40,000 300

40,000 5,000

40,000 3,900

Liabilities Trade payables Total

5,800 46,100

7,700 52,700

4,300 48,200

Statements of financial position

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.6 Solution – RobinHood SA – Inventory measurement (1)

The cost of goods available for sale is €1,170 (360 + 210 + 240 + 360)

(a) FIFO method FIFO method Date

Units Unit cost Total cost

April 27 April 15 April 2

80 40 10

4.5 6 3.5

360 240 35 € 635

Ending inventory Cost of goods sold

1,170 - 635 =

€ 535

(b) LIFO method LIFO method Date April 1 April 2

Units Unit cost Total cost 90 4 360 40 3.5 140 € 500

Ending inventory Cost of goods sold

1,170 - 500 =

€ 670

(c) Weighted average method Weighted average unit cost:

1,170/270 =

€ 4.33

Ending inventory:

130 x 4.33 =

€ 562.9

Cost of goods sold:

1,170 – 562.9 = € 607.1

If a permanent inventory system were used, results would be different for LIFO and weighted average method (see next page).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.6 Solution – RobinHood SA – Inventory measurement (2)

Assuming a permanent inventory system (with intra-period movement follow-up):

Date

Purchases

Sales

Inventory

COGS

FIFO basis 90 @ €4 = €360 April 2

60 * €3,5

April 7

April 15

90 @ €4 = €360 60 @ €3,5 = €210 70

40 * €6

20 @ €4 = €80 60 @ €3,5 = €210

70 @ €4 = €280

20 @ €4 = €80 60 @ €3,5 = €210 40 @ €6 = €240

April 18

30

50 @ €3,5 = €175 40 @ €6 = €240

20 @ €4 = €80 10 @ €3,5 = €35

April 24

40

10 @ €3,5 = €35 40 @ €6 = €240

40 @ €3,5 = €140

April 27

80 * €4,5

10 @ €3,5 = €35 40 @ €6 = €240 80 @ €4,5 = €360

Closing inventory = 35 + 240 + 360 = 635 COGS = 280 + 80 + 35 + 140 = 535 LIFO basis 90 @ €4 = €360 April 2

60 * €3,5

April 7

April 15

90 @ €4 = €360 60 @ €3,5 = €210 70

40 * €6

80 @ €4 = €320

60 @ €3,5 = €210 10 @ €4 = €40

80 @ €4 = €320 40 @ €6 = €240

April 18

30

80 @ €4 = €320 10 @ €6 = €60

30 @ €6 = €180

April 24

40

50 @ €4 = €200

10 @ €6 = €60 30 @ €4 = €120

April 27

80 * €4,5

50 @ €4 = €200 80 @ €4,5 = €360

Closing inventory = 200 + 360 = 560 COGS = 210 + 40 + 180 + 60 + 120 = 610

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.6 Solution – RobinHood SA – Inventory measurement (3)

Date

Purchases

Sales

Inventory

COGS

AVCO basis 90 @ €4 = €360 April 2

60 * €3,5

April 7 April 15

150 @ ([€360+€210]/150) €3,8 = €570

70 40 * €6

80 @ €3,8 = €304

70 @ €3,8 = €266

120 @ ([€304+€240]/120) €4,5 = €544

April 18

30

90 @ €4,5 = €405

30 @ €4,5 = €135

April 24

40

50 @ €4,5 = €225

40 @ €4,5 = €180

April 27

80 * €4,5

130 @ ([€225+€360]/130) €4,5 = €585

Closing inventory = 585 COGS = 266 + 135 + 180

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.7 Solution – Complete missing figures

Opening inventory Closing inventory Purchases Cost of goods sold

A

B

C

D

E

10,650 12,200 110,500 108,950

236 110 937 1,063

647 841 5,122 4,928

9,375 8,760 76,420 77,035

5,296 5,820 34,520 33,996

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.8 Solution – Wholesale wine merchants – Inventory measurement (1) (a) Purchases

Sales

Inventory

FIFO basis: 72 @ €20 = €1,440 (2) 20*€21

(4) 40

32 @ €20 = €640 20 @ €21 = €420

(5) 60*€23

(9) 60

52 @ €23 = €1,196

(12) 35

17 @ €23 = €291

(13) 40*€24

(17) 10

7 @ €23 = €161 40 @ €24 = €960

(20) 50*€25

(22) 30 (23) 30

37 @ €25 = €925

(28) 40

42 @ €26 = €1,092

(24) 45*€26 LIFO basis:

72 @ €20 = €1,440 (2) 20*€21

(3) 40

52 @ €20 = €1,040

(5) 60*€23

(9) 60

52 @ €20 = €1,040

(12) 35

17 @ €20 = €340

(13) 40*€24

(17) 10

17 @ €20 = €340 30 @ €24 = €720

(20) 50*€25

(22) 30 (23) 30

(24) 45*€26

(28) 40

17 @ €20 = €340 20 @ €24 = €480 17 @ €20 = €340 20 @ €24 = €480 5 @ €26 = €130

AVCO basis: 72 @ €20 = €1,440 (2) 20*€21

(3) 40

52/92*(€1,440 + €21*20) = €1,051

(5) 60*€23

(9) 60

52/112*(€1,051 + €23*60) = €1,129

(12) 35

17/52*€1,129 = €369

(13) 40*€24

(17) 10

47/57*(€369 + €24*40) = €1,096

(20) 50*€25

(22) 30 (23) 30

37/97*(€1,096 + €25*50) = €895

(28) 40

42/82*(€895 + €26*45) = €1,058

(24) 45*€26

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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4.8 Solution – Wholesale wine merchants (2)

(b)

FIFO

LIFO

AVCO

Sales

€ 7,570

€ 7,570

€ 7,570

Opening inventory Purchases Closing inventory Cost of goods sold

1,440 5,180 1,092 5,528

1,440 5,180 950 5,670

1,440 5,180 1,058 5,562

Gross Margin

2,042

1,900

2,008

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

4.9 Solution – Pino Fabrics – Net realizable value test

®

According to IAS 2 Inventories, inventory should be measured at the lower of cost and net realisable value (NRV).

Definition: NRV is the estimated selling price in the ordinary course of business less the estimated cost to complete and to dispose of the inventory (i.e., packing, shipping, commissions, …)

If historical cost exceeds NRV, a write-down to NRV should be booked. The amount of a write-down of inventories to NRV is recognized as an expense in the period the write-down occurs.

Pino Fabrics: - the carrying value of product B should be written down to a unitary value of 160 (the NRV).

- total book value of inventory (after write-down) will be 13,280,000.

The carrying value of inventory that has been written down to NRV should be disclosed separately (together with the amount of the write-down (in this case 360,000)).

(Elaborate on the possible sources of an inventory write-down using the definition of NRV.)

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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4.10 Solution – Digit Industries The net realizable value of stage 1 semi-finished product is 360 (560-120-80), so there is no inventory impairment issue with regard to that product The determination of „Net realizable value‟ for work in progress should consider the expected selling price of the finished product in which they will be incorporated.

The profit margin on stage 2 and stage 3 activity (on the estimated cost of completion) should, therefore, be considered when calculating the NRV of work in progress if management has the ability to dispose of the finished product at a price that exceeds production cost.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.1 Solution – Profit forecasts – Depreciation methods

Common elements:

Year

1 €'000

2 €'000

3 €'000

4 €'000

5 €'000

Revenue Expenses (other) Amortise licence Advertising expense Profit before plant depreciation

1,000 (800) (15) (100)

1,000 (800) (15)

1,000 (800) (15)

1,000 (800) (15)

1,000 (800) (15)

85

185

185

185

185

85 (50) 35

185 (50) 135

185 (50) 135

185 (50) 135

185 (50) 135

85 (90) (5)

185 (63) 122

185 (44) 141

185 (31) 154

185 (22) 163

(a) Straight-line Profit as above Plant depreciation Net profit (loss) (b) Diminishing balance Profit as above Plant depreciation Net profit (loss)

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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5.2 Solution – Depreciati Limited – Depreciation methods

a)

Year

Net book value start of year

Annual depreciation expense

Accumulated depreciation

Net book value end of year

20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 20Y4

100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000

10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000

90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000

Year

Net book value – start of year

Depreciation rate

Annual depreciation expense

Accumulated depreciation

Net book value – end of year

20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 20Y4

100,000 81,777 66,874 54,687 44,721 36,572 29,907 24,457

18.22% 18.22% 18.22% 18.22% 18.22% 18.22% 18.22% 18.22%

18,223 14,903 12,187 9,966 8,150 6,665 5,450 4,457

18,223 33,126 45,313 55,279 63,428 70,093 75,543 80,000

81,777 66,874 54,687 44,721 36,572 29,907 24,457 20,000

b) R A n d As d  1 8

20,000 100,000 8 18.22%

20000 100000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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5.3. Solution – Nyvice Limited – Effect of depreciation of PP&E over time and of subsequent sale of PP&E

Depreciation expense (straight-line): Annual depreciation M1 =

4,000

Annual depreciation M2 =

900

Loss on sale of M1 at 31/12/20X9: Proceeds from sale of M1: 6,000 - Net book value of M1 on date of sale: -8,000 Loss on sale of M1 -2,000

Statement of financial position Machine tools (gross) Accumulated depreciation Net book value

Statement of profit or loss Depreciation expense Loss on sale of M1

31/12/20X7

31/12/20X8

31/12/20X9

20,000 -4,000 16,000

24,000 -8,900 15,100

4,000 -1,800 2,200

31/12/20X7

31/12/20X8

31/12/20X9

4,000 0

4,900 0

4,900 2,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.4 Solution – Zetis SA – Depreciation and inventory adjustments (1)

Depreciation adjustment

Inventory adjustment

Closing balances

Assets Land Buildings Acc. depreciation Plant and equipment Acc. depreciation Vehicles Acc. depreciation Inventory at 1 January Trade receivables Cash

150,000 50,000 -4,000 46,800 -19,300 52,500 -27,300 9,400 17,300 24,600

Totals

300,000

-1,000 -7,020 -10,080 +1,250

-18,100

+1,250

150,000 50,000 -5,000 46,800 -26,320 52,500 -37,380 10,650 17,300 24,600 283,150

Financing Share capital Retained earnings Trade payables

100,000 189,300 5,400

100,000 189,300 5,400

Sales Purchases -> Cost of goods sold

247,200

247,200

Salaries Other expenses Depreciation expense

-131,000 -41,300

Totals

300,000

-69,600 +1,250

-68,350 -131,000 -41,300 -18,100

+1,250

283,150

-18,100 -18,100

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.4 Solution – Zetis SA (2)

Statement of profit or loss for 20X1: Sales

247,200

Expenses Cost of goods sold Salaries Other expenses Depreciation expense

68,350 131,000 41,300 18,100 -258,750 -11,550

Loss for the period

Statement of financial position at 31 December 20X1:

Assets

Financing

Land Buildings Acc. depreciation

150,000 50,000 -5,000

Share capital Reserves Loss for the period

100,000 189,300 -11,550

Plant & Equipment Acc. depreciation

46,800 -26,320

Trade payables

5,400

Vehicles Acc. depreciation

52,500 -37,380

Inventory Receivables Bank

10,650 17,300 24,600

Total assets

283,150

Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

283,150

5.5 Solution – Asset cost of new machinery

Item

Total

Asset

Expense

Removal of old machinery Installation of power Resurfacing floor Purchase of new machines Transport to factory Servicing after one month Replacement of conveyor Engineer‟s check

2,800 350 825 62,100 3,200 375 580 250

2,800 350 825 62,100 3,200 250

375 580 -

Labour (300*5.75)

1,725

1,725

-

The choice between capitalisation and expensing is quite problematical in national accounting rules, not least for tax purposes, and practices may differ quite widely from country to country.

The basic accounting rules of IAS 16 Property, Plant and Equipment, however, are straightforward: every cost involved in bringing the asset into service is treated as part of the asset cost.

However, capitalising costs means deferring them for tax purposes and, therefore, paying tax sooner rather than later. All companies would have to capitalise the €62,100 purchase cost, but many companies, if their objective was tax minimization, would be inclined to expense items such as the removal of the old plant and the resurfacing of the floor.

At the same time, it could also be argued that items such as the installation of new power lines and floor resurfacing should be added to the carrying value of the building asset, not the plant (and would be depreciated much more slowly than if part of the machinery).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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5.6 Solution – Bramen NV – Asset cost

1

Yes

2

Yes

3

No

4

No

5

Yes

6

Yes

7

Yes

8

Yes*

9

No

10

No

11

Yes

*In some jurisdictions financial discounts on purchases are accounted for as financial income and not as a reduction of the net purchase cost. This would not be consistent with how IFRS 15 Revenue from Contracts with Customers deals with financial discounts offered to customers (IFRS 15 considers such financial discounts as variable consideration and, consequently, estimated discounts would be deducted from recognized revenue).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.7 Solution – Machinery Unlimited – Depreciation methods

Gross asset cost = €70,000 Depreciable amount = €70,000 - €14,200 = €55,800

Straight-line depreciation method:

Year

Asset cost

Depreciation expense

Asset book value

20X1

70,000

9,300

60,700

20X2

9,300

51,400

20X3

9,300

42,100

20X4

9,300

32,800

20X5

9,300

23,500

20X6

9,300

14,200

Depletion method: Estimated total mileage over the 6-year period = 100,000 Depreciation percentage year 20X1 = 18%.

Year

Asset cost

Depreciation expense

Asset book value

20X1

70,000

10,044

59,956

20X2

10,044

49,912

20X3

10,044

39,868

20X4

10,044

29,824

20X5

7,812

22,012

20X6

7,812

14,200

The depletion method minimizes income tax payments in the early years of asset use.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.8 Solution – Jolly SA – Depreciation methods and disposal gain or loss

a) Office building Annual depreciation expense =

600,000  60,000  120,000  18,000 30 Year 1 2 …

30 31

Asset cost 660.000

Annual depreciation expense 9.000 18.000 …

18.000 9.000

Net book value 651.000 633.000 …

129.000 120.000

Annual depreciation expense 11.120 6.672 4.003

Net book value 16.680 10.008 6.005

Production equipment

d  1 3

6,000  0.40 27,800

Year 1 2 3

Asset cost 27.800

b) Book value of the production equipment after two years = €10,008 Selling price = €12,000  Gain on disposal = €1,992  Decrease of assets: €10,008 (equipment: acquisition cost minus €27,800, accum. depreciation minus €17,792)  Increase of receivables or cash: €12,000 c) If offer price for production equipment = €8,000  Loss on disposal of €2,008  Decrease of assets: 10,008 (equipment: acquisition cost minus €27,800, accum. depreciation minus €17,792)  Increase of receivables or cash: €8,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.9 Solution – Intange NV – Intangible assets (1)

a)

Television advertising campaign

lAS 38 Intangibles (par.69) states that advertising and promotional costs should be recognized as an expense when incurred.

This is because company has insufficient control over the resource (and its future economic benefits); The expected future economic benefits resulting from the television advertising campaign are uncertain and they are beyond the control of the company.

However, because the year-end is halfway through the campaign there is a €2.5m prepayment to be recognized as a current asset (refer to the concept of „deferred expenses‟ here – to be considered as a kind of inventory asset of future services acquired).

b)

Research on a processor chip

The work on the new processor chip is research with the aim of eventually moving into development work. IAS 38 Intangibles requires all research expenditure to be expensed as incurred.

Consequently, the expenditure on training cannot be treated as an asset and must be taken as an expense in profit or loss.

Even at the development stage, it will not be possible to capitalize the development costs unless they satisfy the additional lAS 38 recognition criteria.

When the recognition criteria are satisfied and development costs can be capitalized, it will still not be possible to go back and capitalize the research costs incurred in the past.

The company's past successful history makes no difference to this.

c)

Process reengineering project

This project qualifies as development work from 30 September 20X8 on, as the lAS 38 recognition criteria are met from that day on. Only costs incurred after the relevant conditions have been satisfied (30 September 20X8) can be capitalized (3 million in this case).

All previous costs must be expensed, even those arising earlier in the same accounting period.

Amortization of the capitalized costs begins when the process is commercially exploited, and a full year‟s charge would be 300,000 (3 million/10). The amortization expense in the year ended 30 June 20X9, would be 75,000 (300,000 x 3/12).

d)

Training courses

lAS 38 Intangibles indicates that a company usually has insufficient control over a team of skilled staff as a resource and the future economic benefits arising from those skills. This would apply here.

Intange's trained staff may stay with the company for the next four years or they may decide to leave and take their skills with them. Intange has no control over that. In other words, trained staff are free to leave and work for someone else.

Training is considered to be part of the general cost of developing a business as a whole.

Consequently, the expenditure on training cannot be treated as an asset and must be taken as an expense in profit or loss.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.9 Solution – Intange NV – Intangible assets (2)

e)

License renewal

According to lAS 38 Intangibles separately purchased intangibles are recognized and initially measured at cost; they are to be amortised over their useful economic lives (for the licence this is 5 years). The annual amortization expense would be 40,000 The carrying value (net book value) of the licence at 30 June 20X9 would be 180,000 (200,000 minus 40,000/2).

Impairment testing?

Although the asset‟s net selling price (fair value less costs of disposal) is only €175,000, the value in use is estimated to be €185,000, so the recoverable amount of the asset is above €185,000 and no impairment has occurred.

f)

Commissioned research

The research work on the new electronics component of the graphic systems manufactured by the customer is quite different from the research work on the processor chip (see above). This is because here the work has been commissioned by a customer and the customer will be paying, regardless of the outcome of the research.

In this situation, as long as Intange NV has no reason to believe that the customer will not meet the costs in full, the costs should be treated as work in progress, rather than being capitalized as an intangible assets or charged to profit or loss.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.10 Solution – Alder Repair Company – Lease accounting (1)

On 1 January 20X5, Alder Repair Company leases a highly specialized machine tool from Top Equipment Incorporated, the manufacturer of those tools. The lease agreement specifies the fair value of the specialized machine tool on 1 January 20X5 ($309,250), the lease term (3 years) and the annual lease payments ($120,000) payable at the end of each year. The specialized machine tool has a three-year economic life and is expected to have zero residual value. The interest rate implicit in the annual lease payments amounts to 8%. The lease payments do not include extra fees for services provided by Top Equipment . If needed, these supplementary services would be charged separately.

Similar machine tools are depreciated on a straight-line basis by Alder Repair Company.

Accounting for a finance lease: On 1 January 20X5 (date of the lease contract), Alder Repair Company records a non-current (fixed) asset (+ A) and a corresponding liability of 309,250 (+ L). This amount is equal to both the fair value of the leased asset and the present value of the lease payment obligations of Alder Repair Company.

The accounting entries can be followed in Table 1.

Table 1 - Alder Repair Company (lessee): Financial statement impact of finance lease Assets Leased assets 309,250

Balance start 20X5

= Cash

Liabilities

+

Lease liability 309,250

:

Equity Profit for year :

During year 20X5 Depreciation of asset -103,083

Lease payment (and recognition of interest) End 20X5 balance

=

-120,000

206,167

=

:

-95,260

-103,083 (Depreciation expense) -24,740 (Interest expense)

213,990

:

-102,881 111,109

-103,083 -17,119 :

During year 20X6 Depreciation of the asset -103,083 Lease payment End 20X6 balance

103,084

-120,000 :

= =

During year 20X7 Depreciation of the asset -103,084 Lease payment End 20X7 balance Effect of lease on Cash and Equity, years 20X520X7

= -120,000

0

=

-103,084 -111,109 0

-360,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-8,891

-360,000

5.10 Solution – Alder Repair Company – Lease accounting (2)

So, the leased machine tool is presented in the statement of financial position as a non-current asset with a corresponding lease liability. The lease liability is economically equivalent to a loan from Top Equipment to Alder Repair Company. The balance sheet on 1 January 20X5 would show the principal amount (95,260) of the first payment of 120,000 as a current liability, and the balance (213,990) as a non-current liability.

For each of the years 20X5 to 20X7, Alder Repair will recognize in its statement of profit or loss the depreciation expense of the asset (straight-line depreciation over 3 years) and the interest expense of Top Equipment‟s loan.

The annual depreciation expense amounts to 103,083 (309,250/3), knowing that the asset‟s useful life is equal to the lease term (3 years).

The interest expense of the implicit loan is measured using the interest method. In order to calculate the annual interest expense, Alder Repair would apply the discount rate implicit in the lease (8%) to the balance of the liability at the start of the fiscal year.

In 20X5, the interest expense amounts to 24,740 (309,250 x 8%). The annual interest expense can be accrued over the year or can be recognized annually at the time of the first annual lease payment of 120,000. The balance of the first-year payment (95,260) represents the payment of the principal (the repayment part) of the lease liability. The carrying amount of the lease liability at the end of 20X5 is 213,990, being the initial amount (309,250) minus the repayment of the principal in year 20X5 (95,260). The new carrying amount will then be used to calculate the interest expense for year 20X6 and the ending balance of the lease liability at year-end 20X6 (see Table 2 for further elaboration).

Accounting for an operating lease: Accounting for an operating lease would be relatively easy: there would be no impact on the statement of financial position and the annual lease payment of 120,000 would be recognized as an annual rent expense. So, there would be no lease asset and no lease liability on the balance sheet (this could have a significant effect on the company‟s ratios which use total assets and debt, such as gearing ratios and return on assets).

Table 3 shows the impact of the two methods on the profit (before tax) of Alder Repair Company.

Initially, the finance lease method would lead to lower pre-tax profit as the combined depreciation and interest expenses would be larger than the rent expense. The difference does however reverse over time as the interest expense decreases over time.

Note that total expenses recognized over the three-year contract would be 360,000 in each case and that the method choice would have no impact of Alder Repair‟s (pre-tax) cash flows.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

5.10 Solution – Alder Repair Company – Lease accounting (3)

Table 2 - Calculation of interest expense and end-year liability

Year

(1) Lease liability at 1/1

(2) Lease payment at 31/12

(3) Interest expense 8% x (1)

(4) Reduction in liability (2)-(3)

(5) End-year liability (1)-(4)

20X5 20X6 20X7

309,250 213,990 111,109

120,00 120,00 120,00

24,740 17,119 8,891*

95,260 102,881 111,109

213,990 111,109 0

*Rounded

Calculation of annual depreciation expense =

=

Table 3 - Alder Repair Company (lessee): statement of P/L impact of lease asset under operating and finance lease methods

Year

Operating lease

Finance lease

20X5

Rent expense

120,000

Depreciation expense Interest expense

103,083 24,740 127,823

20X6

Rent expense

120,000

Depreciation expense Interest expense

103,083 17,119 120,202

20X7

Rent expense

120,000

Depreciation expense Interest expense

103,084 8,891 111,975

Total

360,000

Total

360,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.1 Solution – Arlington SA – Year-end adjustments (1)

Worksheet

Trial balance

Premises Motor vehicles Acc. depreciation Investments Inventory Trade receivables Bank Prepayments

130,000 48,000 -12,000 45,800 21,250 39,250 70,420

Totals

342,720

Ordinary shares Preference shares Reserves Preference dividend Ordinary dividend 12% Debenture Trade payables Accrued expenses

100,000 50,000 48,220 -2,500 -5,000 50,000 23,600

Adjustments

Sales Purchases Administration expenses

476,900 -219,700 -73,200

Distribution costs Debenture interest Bad debt expense Impairment loss Depreciation expense Income tax expense

-102,600 -3,000

+950 -15,900

326,820

-12,000 -1,700 -1,950 -1,200

100,000 50,000 40,720

-7,500 2,500 5,000

-1,950 -5,000 +950 -480 -620 -3,000 -1,200 -1,700 -12,000 -20,000

Profit

50,000 23,600 9,100

20,000

476,900 -221,650 -77,730

-103,220 -6,000 -1,200 -1,700 -12,000 -20,000 33,400

342,720

Statement of financial position 130,000 48,000 -24,000 44,100 19,300 38,050 70,420 950

+3,000 +5,000 +1,100 +20,000

Taxes payable

Totals

Statement of profit or loss

-15,900

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

33,400 326,820

6.1 Solution – Arlington SA (2)

Statement of profit or loss

Sales Cost of sales

476,900 -221,650 255,250

Administrative expenses Distribution costs Bad debt expense* Impairment loss on investments* Operating profit

-77,730 -115,220 -1,200 -1,700

Interest expense Profit before tax Income tax Net profit for the period

-195,850 59,400 -6,000 53,400 -20,000 33,400

* Discuss classification issue for these items

Statement of financial position Assets

Financing

Non-current assets Premises

130,000

Motor vehicles Acc. depreciation Investments Acc. impairment loss

48,000 -24,000 45,800 -1,700

Current assets Inventory Trade receivables Prepayments Cash and cash equivalents

19,300 38,050 950 70,420

Total assets

326,820

Equity Share capital (ordinary + preferred) Reserves Profit for the period

150,000 40,720 33,400

Liabilities Long-term debt (12% debenture) Taxes payable Trade payables Accrued expenses

50,000 20,000 23,600 9,100

Total equity and liabilities

326,820

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.2 Solution – Requirements for provision accounting

Relevant standard = IAS 37 Provisions, Contingent Liabilities and Contingent Assets a) Sales with product warranty The obligating event is the sale of the product with warranty. This gives rise to a legal obligation.

Historical evidence indicates that it is probable that there will be warranty claims for the products sold.

A provision is recognized for the best estimate of the future costs of replacing defective products which were sold before the reporting date. b) Environmental remediation costs The critical element in deciding on recognizing a provision is the presence of a legal or constructive obligation to incur the remediation costs. If such an obligation does not exist, a provision will not be recognized. c) Litigation If available evidence brings the company‟s legal advisors to the opinion that it is more likely than not that the company will lose the lawsuit, a provision will be recognized for the estimated settlement costs. If the chance of losing the lawsuit is less than 50% (but not remote), the pending lawsuit will be treated as a contingent liability. In case of a contingent liability, the company does not record a provision, but discloses the pending lawsuit in the notes to the accounts. d) Overhaul and maintenance costs Although the periodic overhaul of the aircraft is a legal obligation, the company can consider alternative actions to avoid the overhaul costs, for example by selling the aircraft before the end of the 3-year period. So, a provision for overhaul and maintenance costs should not be recognized. Instead, the components approach of IAS 16 will be used to account for the scheduled overhaul and maintenance costs as a component of the acquisition cost of the aircraft to be depreciated over the 3year period. e) Closure of a division The past obligating event for the company is the communication of the decision to close down the division to the works council and the employees affected. This gives rise to a constructive obligation by the end of the year, as it creates a valid expectation that the division will be closed. An outflow of resources in settlement is probable and reliably estimated. At year-end a provision will be recognized for the best estimate of the restructuring costs. f) Refunds policy The refunds are a present obligation as a result of a past event. The past event is the sale of the goods. The sale of the goods gives rise to a constructive obligation because the conduct of the company (its widely published refunds policy) had created a valid expectation on the part of its customers that the company will refund purchases. The refunds will result in a sacrifice of resources (an outflow of resources) in settlement. It is probable that a percentage of the goods will be returned to refund. A provision will be recognized for the best estimate of the refunds.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.3 Solution – Greenfield Dynamics– Provision measurement

a) The warranty provision will be measured at the expected value of the warranty costs €575,000.

Expected warranty costs: % No defects Major defects Minor defects Total

85% 5% 10% 100%

Units 4,250 250 500 5,000

Cost per unit 0 500 900

Total costs 0 125,000 450,000 €575,000

b) The provision for the tax dispute will be measured at the most likely outcome - €100,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.4 Solution – Dinasus Ltd – Impairment test

IAS 36 Impairment of Assets requires that assets are not to be carried at values in excess of their recoverable amount. An asset is regarded as impaired if its carrying amount exceeds the recoverable amount. The recoverable amount is the higher of an asset‟s „fair value less costs of disposal‟ and its „value in use‟.

Impairment test at end of accounting period 20X6: > Recoverable amount = higher of: 1) fair value less costs of disposal (net selling price) = £950,000 2) value in use = £800,00.

Thus, the recoverable amount = £950,000 > Net book value = one fifth of acquisition value = £600,000 => There is no impairment loss as the net book value at test date (end of accounting period 20X6) is lower than the recoverable amount.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.5 Solution – Biaz Company – Depreciation after impairment loss

Annual depreciation expense before impairment: 4,000 Book value at the end of 20X3: 20,000 – (3 x 4,000) = 8,000 Recoverable amount = 6,000 Impairment loss at end of 20X3= 2,000 Annual depreciation expense after impairment: 6,000/2 = 3,000 Book value at the end of 20X4: 6,000 – 3,000 = 3,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

6.6 Solution – Teleconstruct The carrying amount of the plant at 31 March 20X2, before the impairment review, is €500,000 (800,000 – (150,000 x 2)) where €150,000 is the annual depreciation expense ((800,000 cost – 50,000 residual value)/5 years).

This needs to be compared with the recoverable amount of the plant which must be its value in use as no fair value can be established at this date.

Value in use: Cash flow €’000 year ended:

31 March 20X3 31 March 20X4 31 March 20X5

220 180 170 + 50

Discount factor Present value at 10% €’000 0.91 0.83 0.75

200,200 149,400 165,000 ––––----514,600 ––––-----

Note: Stress the estimated residual value of the plant as an additional cash inflow at the end of the asset‟s useful life.

At 31 March 20X2, the plant‟s value in use of €514,600 is greater than its carrying amount of €500,000. This means the plant is not impaired and it should continue to be carried at €500,000.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

7.1 Solution - Arénières Inc – Preparing financial statements (1) Worksheet

Trial balance

Land Buildings Acc. depreciation - buildings Equipment Acc. depreciation - equipment Inventory Trade receivables Prepaid expenses Bank

82,100 120,000 -36,000 89,500 -53,700 214,300 91,300

Totals

590,700

Share capital Retained earnings Interim dividend Provision – claim Taxes payable Debenture Trade payables Accrued expenses

100,000 185,600 -25,000

Sales Purchases Salaries Other operating expenses

942,700 -398,100 -343,600 -102,200

Provision for claim Interest expense Depreciation expense Income tax expense

Statement of profit or loss

Statement of financial position 82,100 120,000 -38,400 89,500 -71,600 216,300 91,300 750 83,200

-2,400 -17,900 +2,000 +750

83,200 -17,550

573,150

100,000 160,600 +10,000 +15,000

10,000 15,000 50,000 184,800 22,550

50,000 184,800 +20,000 +2,550

+2,000 -20,000 -2,550 +750 -10,000

-3,500 -20,300 -15,000

Profit Totals

Adjustments

942,700 -396,100 -343,600 -124,000

-10,000 -3,500 -20,300 -15,000 30,200

590,700

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

30,200 573,150

7.1 Solution - Arénières Inc (2)

Statement of profit or loss Sales Cost of goods sold Salaries Other operating expenses Depreciation expense Provision expense Profit from operations Interest expense Profit before tax Income tax expense Net profit for the period

942,700 -396,100 546,600 -343,600 -124,000 -20,300 -10,000

-497,900 48,700 -3,500 45,200 -15,000 30,200

Statement of financial position as at 31 December 20X4 Non-current assets Land Buildings Acc. depreciation buildings Equipment Acc. depreciation equipment

120,000 38,400 89,500 71,600

Current assets Inventory Trade receivables Prepayments Cash and cash equivalents

216,300 91,300 750 83,200

Total assets

82,100 81,600 17,900 181,600

391,550 573,150

Equity Share capital Retained earnings Profit for the year

100,000 160,600 30,200 290,800

Liabilities Provisions Taxes payable Debenture Trade payables Accrued expenses

10,000 15,000 50,000 184,800 22,550

Total equity and liabilities

573,150

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

7.2 Solution - Ansermet SA – Preparing financial statements (1) Worksheet

Trial balance

Land Buildings Acc. depreciation buildings Plant Acc. depreciation plant Inventory Trade receivables Bank

155,000 560,000 -112,000 1,890,200 -1,039,610 619,300 414,700 208,100

Total

2,695,690

Share capital Share premium Retained earnings Long-term debt Provisions Taxes payable Trade payables Accrued expenses

Sales Purchases Personnel expenses Other operating expenses

Adjustments

Statement of profit or loss

155,000 560,000 -123,200 1,890,200 -1,294,787 584,600 414,700 208,100

-11,200 -255,177 -34,700

-301,077

2,394,613

750,000 220,000 254,790 600,000

750,000 220,000 254,790 600,000 20,000 60,000 336,800 94,750

+20,000 +60,000 336,800 +50,000 +2,750 +42,000 2,740,500 -1,247,000 -691,300 -268,100

Depreciation expense Provision expense Interest expense Income tax expense

-34,700 -50,000 -2,750 -266,377 -20,000 -42,000 -60,000

2,740,500 -1,281,700 -691,300 -320,850 -266,377 -20,000 -42,000 -60,000

Profit Total

58,273 2,695,690

Statement of financial position

-301,080

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

58,273 2,394,613

7.2 Solution - Ansermet SA (2)

Statement of profit or loss Sales

2,740,500

Expenses Cost of goods sold Personnel expenses Other operating expenses Depreciation expenses Provision expense Profit before interest and tax Interest expense Profit before tax Income tax expense Net profit for the period

-1,281,700 -691,300 -320,850 -266,377 -20,000

-2,580,233 160,273 -42,000 118,273 -60,000 58,273

Statement of financial position at 31 December 20X6 Assets

Financing

Non-current assets Land Buildings Acc. depreciation Plant Acc. depreciation Current assets Inventory Trade receivables Bank

Total assets

155,000 560,000 -123,200 1,890,200 -1,294,787

584,600 414,700 208,100

2,394,613

Equity Share capital Share premium Retained earnings Profit for the year

750,000 220,000 254,790 58,273

Liabilities Provision Long-term debt Taxes payable Trade payables Accrued expenses

20,000 600,000 60,000 336,800 94,750

Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

2,394,613

7.3 Solution - Agrestic Corp. – Preparing financial statements (1)

Worksheet Trial balance

Land Buildings Acc. depreciation buildings Equipment Acc. depreciation equipment Trade receivables Cash and cash equivalents Inventory (raw materials and consumables) Prepayments Total

200,000 630,000 -84,000 108,000 -27,610 253,800 120,730 685,260

1,886,180

Share capital Retained earnings Trade payables Other payables Long-term debt Provisions

Adjustments

Statement of profit or loss

-126,800 2,000

200,000 630,000 -105,000 108,000 -51,727 248,724 120,730 558,460 2,000

-174,993

1,711,187

-21,000 -24,117 -5,076

800,000 65,000 95,420

Accrued expenses Taxes payable Revenue Purchases Salaries Other operating expenses

2,465,300 -1,258,000 -420,800 -210,740

Depreciation expense Provision expense Interest expense Bad debt allowance Income tax expense

80,000 -50,000 20,000 5,500 120,000

-126,800 -20,000 2,000 -46,000 -45,117 -80,000 50,000 -5,500 -5,076 -120,000

Profit Total

800,000 65,000 95,420 46,000 300,000 80,000

46,000 300,000 50,000

25,500 120,000 2,465,300 -1,384,800 -420,800 -274,740

-45,117 -30,000 -5,500 -5,076 -120,000 179,267

1,886,180

Statement of financial position

-174,993

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

179,267 1,711,187

7.3 Solution - Agrestic Corp. (2)

Statement of profit or loss Revenue Cost of goods sold

Salaries Depreciation expense Provision expense Other operating expenses Bad debt allowance Profit from operations Interest expense Profit before tax Income tax expense Net profit for the period

2,465,300 -1,384,800 1,080,500 -420,800 -45,117 -30,000 -274,740 -5,076

-775,733 304,767 -5,500 299,267 -120,000 179,267

Statement of financial position at 31 December 20X4 Non-current assets Land Buildings Less Acc. depreciation buildings Equipment Less Acc. depreciation equipment

200,000 630,000 -105,000 108,000 -51,727

781,273

Current assets Inventory (raw materials and consumables) Trade receivables Prepayments Cash and cash equivalents

558,460 248,724 2,000 120,730

929,914

Total assets

1,711,187

Equity Share capital Retained earnings Profit for the year

800,000 65,000 179,267

Liabilities Long-term debt Provisions Taxes payable Trade payables Other payables Accrued expenses

300,000 80,000 120,000 95,420 46,000 25,500

Total equity and liabilities

1,044,267

666,920

1,711,187

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

7.4 Solution – Mare’s Nest – Preparing financial statements (1) Worksheet Trial balance

Adjustments

Statement of profit or loss

Statement of financial position

Land Buildings Acc. depreciation buildings Equipment Acc. depreciation equipment Trade receivables Long-term receivables Cash and cash equivalents Inventory (raw materials and consumables) Accrued income Prepayments

450,000 1,320,000 -640,000 1,652,000 -495,600 489,000 65,000 365,200 896,600

-165,200

Total

4,102,200

40,400

4,142,600

Share capital Retained earnings Trade payables Long-term debt Provisions Accrued expenses Prepaid income Taxes payable

1,500,000 185,000 854,000 1,000,000 250,000 125,000 12,000 100,000

1,500,000 185,000 854,000 1,000,000 250,000 125,000 12,000 100,000

Sales/Revenue Other operating income Cost of sales

4,638,500 126,500 -2,805,000

Distribution costs Administrative expenses

-897,800 -690,800

Interest expense Interest income Income tax expense

-58,200

-40,000

237,200 200 5,000 3,200

-12,000 237,200 -123,120 3,200 -41,040 5,000 -125,000 -41,040 200 -100,000

Profit Total

450,000 1,320,000 -680,000 1,652,000 -660,800 489,000 65,000 365,200 1,133,800 200 8,200

4,638,500 114,500 -2,687,720

-938,840 -851,840

-58,200 200 -100,000 116,600

4,102,200

40,400

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

116,600 4,142,600

7.4 Solution - Mare’s Nest (2) Statement of profit or loss Sales Cost of sales Gross profit Other operating income Distribution costs Administrative expenses Profit from operations Finance income Finance cost Profit before tax Income tax expense Net profit for the period

4,638,500 -2,687,720 1,950,780 114,500 -938,840 -851,840 274,600 200 -58,200 216,600 -100,000 116,600

Statement of financial position at 31 December 20X4 Non-current assets Land Buildings Less Acc. depreciation buildings Equipment Less Acc. depreciation equipment Long-term receivables

450,000 1,320,000 -680,000 1,652,000 -660,800 65,000

2,146,200

Current assets Inventory (raw materials and consumables) Trade receivables Accrued income Prepayments Cash and cash equivalents

1,133,800 489,000 200 8,200 365,200

1,996,400

Total assets

4,142,600

Equity Share capital Retained earnings Profit for the year

1,500,000 185,000 116,600

Liabilities Long-term debt Taxes payable Trade payables Provisions Prepaid income Accrued expenses

1,000,000 100,000 854,000 250,000 12,000 125,000

Total equity and liabilities

1,801,600

2,341,000

4,142,600

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

7.5 Solution – Gearcorp – Year-end adjustments (1)

Worksheet:

Trial balance Land Buildings Acc. depreciation Buildings Equipment Acc. depreciation Equipment Inventory Trade receivables Cash and cash equivalents Prepayments

250,000 1,250,000 -437,500 595,000 -178,500 260,490 280,300 1,040,000

Totals

3,059,790

Share capital Retained earnings Long-term debt Trade payables Accrued expenses Provision Taxes payable

Sales Purchases Salaries Other operating expenses

Interest expense Provision expense Depreciation expense Income tax expense

Adjustments

Statement of profit or loss

250,000 1,250,000 -500,000 595,000 -303,450 320,550 280,300 1,040,000 6,200

-62,500 -124,950 60,060

5,000 1,200

-121,190

2,938,600

110,000 30,000 72,000

650,000 230,000 960,000 675,900 110,000 30,000 72,000

650,000 230,000 960,000 675,900

1,810,410 -627,360 -482,630 -120,530

60,060

1,810,410 -567,300 -482,630

5,000 -110,000 1,200

-36,000 -30.000 -187,450 -72,000

Profit

Totals

-224,330 -36,000 -30,000 -187,450 -72,000 210,700

3,059,790

Statement of financial position

-121,190

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

210,700

2,938,600

7.5 Solution – Gearcorp (2) Statement of profit or loss (formal IFRS Standards terminology)

Revenue Cost of goods sold

1,810,410 -567,300 1,243,110

Salaries Depreciation expense Other operating expenses Profit from operations Finance cost Profit before tax Income tax expense Net profit after tax

-482,630 -187,450 -254,330

-924,410 318,700 -36,000 282,700 -72,000 210,700

Statement of financial position Non-current assets Land Buildings Less Acc. depreciation Equipment Less Acc. depreciation

1,250,000 -500,000 595,000 -303,450

Current Assets Inventories Trade receivables Prepayments Cash and cash equivalents

320,550 280,300 6,200 1,040,000

Total assets

250,000 750,000 291,550 1,291,550

1,647,050 2,938,600

Equity Share capital Retained earnings Profit for the year Liabilities Long-term debt Provision Taxes payable Trade payables Accrued expenses Total equity and liabilities

650,000 230,000 210,700 1,090,700 960,000 30,000 72,000 675,900 110,000 2,938,600

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.1 Solution – Calculate ratios

Ratios: Management performance ratios A. Profitability ratios ROE ROA ROCE EPS Gross operating margin Net operating margin Net profit margin

8.85% 8.25% 10.45% 0.2 55.91% 21.98% 6.87%

B. Asset utilization ratios Total asset turnover Long-term asset turnover Inventory turnover

0.54 1.11 0.78

Financial strength ratios A. Long-term solvency risk ratios Gearing Gearing (Total finance) Interest cover

88.50% 46.95% 1.83

B. Short-term liquidity ratios Current ratio Acid test Days inventory outstanding Credit given Credit obtained

2.43 0.99 467.90 0.00 324.63

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.2 Solution – Medmove

Calculation of equity by difference: (total assets less liabilities) 20X1 2,865 - 220 = 2,645 20X2 3,360 - 600 = 2,760 20X3 4,505 - 1,700 = 2,805 (i) Current ratios: 20X1 515 / 220 = 2.34 20X2 460/600 = 0.77 20X3 705 / 200 = 3.53 Industry 25 / 10 = 2.5 Debt/Equity: No debt in 20X1 and 20X2 20X3 1,500 / 2,805 or 53.5% Industry 20/70 or 28.6% (ii) Commentary We have no statement of profit or loss at our disposal, so we can only comment on certain aspects of the company. Overall, the company has expanded its asset base very rapidly (from 2,350 in 20X1 to 3,800 in 20X3, an increase of 62% in two years) without increasing its net equity significantly, but rather by borrowing (zero gearing in 20X1, 53.5% in 20X3).

It appears that the company may have embarked upon an asset growth phase without the appropriate financing, in that the 20X2 statement of financial position reveals an increase in long-term assets and severe strain on short-term financing. The current ratio has dropped from 2.34 (near the industry average of 2.5) to 0.77. Short-term payables have increased 3 times, and cash has disappeared, arguing that the company has financed its asset acquisition through either short-term borrowing or by taking extra credit from suppliers.

This situation is corrected in 20X3 with substantial long-term borrowing. The company is now cash rich and its current ratio has climbed to 3.53, from which one might deduce that either further acquisitions are planned, or that the management has over-reacted to the cash shortage in 20X2.

Without earnings data, we cannot comment on the evolution of the equity component of the statement of financial position. It is possible that the company has remained profitable, and there has been no further equity subscribed, or conversely that new equity has been contributed and this has been eroded by an operating loss.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.3 Solution – Company RATIS (1)

Ratios:

20X2

20X3

20X4

Management Performance ratios A. Profitability ratios ROE ROA ROCE EPS Gross operating margin Net operating margin Net profit margin

19.2% 14.0% 16.3% 0.505 65.0% 16.7% 9.8%

18.4% 12.8% 14.6% 0.596 67.0% 19.0% 9.6%

13.4% 11.9% 13.3% 0.486 65.0% 16.7% 7.7%

1.28 1.99 5.0 10.00

1.03 1.40 5.0 10.00

1.07 1.54 4.0 8.34

32% 24% 10.3

64% 39% 4.6

46% 31% 3.4

2.50 1.87 73.00 36.50 60.89

2.20 1.64 73.06 36.50 73.06

2.85 1.93 91.28 43.78 60.90

B. Asset utilization ratios Total asset turnover Long-term asset turnover Inventory turnover Receivables turnover

Financial strength ratios A. Long-term solvency risk ratios Gearing Gearing (Total finance) Interest cover

B. Short-term liquidity ratios Current ratio Acid test Days inventory outstanding Credit given Credit obtained

Overall, RATIS appears to be a company which has embarked upon an expansion programme in 20X3, largely financed by debt, and has been hit in 20X4 by an increase in interest rates and possibly a contraction in the demand for the product. The company has managed, notwithstanding, to reduce its debt in 20X4 which suggests it should be able to trade back to a less risky and more profitable position.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.3 Solution – Company RATIS (2) In 20X3 there was an increase of €220,000 in net long-term assets (+70%) which was financed mostly by an increase of €150,000 in long-term debt. This changed the company from a reasonable level of gearing (31.7%) to a riskier level of 64.4%. Ordinarily, this should have been accompanied by an increase in earnings to compensate shareholders for the increased risk, and eps did indeed rise from €0.51 to €0.60.

The arrival of the new equipment was accompanied by an increase in sales (20%) and an increase in gross operating margin from 65% to 67%, although distribution costs went up to 35% of sales from 33%.

It looks as though interest rates increased - we do not know the timing of the loans, but making an assumption that they occurred at the start of the year, the effective rate of interest went up from (10/100=) 10% in 20X2 to (30.9/250=) 12.4% in 20X3 to (37.5/200=) 18.75% in 20X4. This demonstrates the risk of a highly geared company - the exposure to interest rate changes. It looks as though the management reacted to the changes by repaying debt early (all debt was classified as long-term in 20X3, even though some was repaid in 20X4). Given that margin has fallen, it may also be that demand for the product was sluggish and the management reduced prices to maintain throughput. The increase in receivable levels (12% of sales in 20X4 against 10% in 20X3) suggests that credit may also have been used as a selling tool. Inventory levels are 25% of cost of sales in 20X4 against 20% in 20X3, suggesting that either inventory control is slipping, or the company was geared up for higher volumes than it actually achieved.

Overall, the company has set out upon an expansion plan which has hit problems. ROCE has dropped consistently over the three years (from 16.3% to 13.3%), but this may be blamed in part upon poor market conditions. ROE has dropped even more due to the interest burden (you may wish to elaborate on ‘financial leverage’ here). It looks as though the management is reacting vigorously to the market changes and, given more intense cost control, will trade through to higher profitability.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.4 Solution – Ratio puzzle 1

Acid test ratio = (Cash + Receivables (a)) / Current liabilities Acid test ratio = (30,000 + 20,000) / 20,000 = 2.5

Current ratio= (Cash + Receivables (a) + Inventories (c)) / Current liabilities Current ratio = (30,000 + 20,000 + 20,000) / 20,000 = 3.5 Gearing = Debt / Equity = Long-term borrowing (d) / (Share capital + Retained earnings) Gearing = 20,000 / 40,000 = 0.5

Calculation of a, b, c, d (a) = (2.5 * 20,000) – 30,000 = 20,000 (b) = (3.5 * 20,000) – 30,000 – 20,000 = 20,000 (c) = (0.5 * 40,000) = 20,000 (d) = 80,000

Statement of financial position

Long-term assets Cash Receivables Inventories

Assets 10,000 30,000 (a) 20,000 (b) 20,000

Equity & Liabilities Share capital Retained earnings Trade payables Long-term borrowing

35,000 5,000 20,000 (c) 20,000

Total

(d) 80,000

Total

(d) 80,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.5 Solution – Ratio puzzle 2

Net operating margin = Profit before interest and tax / Sales Return on equity = Profit for the period / Equity Income tax expense = Income tax rate * Profit before tax

Calculations 1. Profit for the period = Return on equity * Equity = 3,600 * 22% = 792 2. Profit for the period = Profit before tax * (1 - Income tax rate) Profit before tax = 792 / (1 – 0.10) = 880 3. Income tax expense = 880 – 792 = 88 4. Profit before interest and tax = Profit before tax + Interest expense = 880 + 413 = 1,293 5. Net operating margin = Profit before interest and tax / Sales Sales = Profit before interest and tax / Net operating margin = 1,293 / 24% = 5,387 6. Cost of sales and Other operating expenses = Sales - Profit before interest and tax Cost of sales and Other operating expenses = 5,387 – 1,293 = 4,094

Statement of profit or loss

Sales Cost of sales and Other operating expenses Profit before interest and tax Interest expense Profit before tax Income tax expense Net profit for the period

5,387 -4,094 1,293 -413 880 -88 792

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.6 Solution – Gunge AG and Guntzel AG

Gunge AG and Guntzel AG are both wholesale companies operating in the same business segment.

Although they end up with the same net operating margin, a number of other ratios show significant differences. The largest differences relate to credit given, gross operating margin and days inventory outstanding. These three ratios hold significant clues on their customer approach.

-

For Gunge the credit given ratio is 59 days compared to 19 days for Guntzel. Customers of Guntzel have to pay a lot quicker than those of Gunge. Gunge customers get credit for an average period of 59 days whereas Guntzel customers only for 19 days. If credit and payment terms are important for customers, customer service level is higher in this regard for Gunge.

-

For Gunge the gross operating margin is much higher (42%) than for Guntzel (17%). The gross operating margin depends on cost of sales per unit (including cost of goods sold per unit) and on sales price per unit. Assuming the same kind of sourcing (equivalent cost of goods sold), the difference in the ratio indicates that the sales price level of Gunge is considerably higher than that of Guntzel. Price competitiveness seems to be much more important to Guntzel than to Gunge.

-

The number of days inventory outstanding is much larger for Gunge (50 days) than for Guntzel (21 days). This indicates that Gunge holds more inventory, possibly to offer a wider range of products and to allow instant delivery of its goods. This suggests better customer service with regard to customer choice and speed of delivery.

Although gross operating margin is quite different for Gunge and Guntzel, net operating margin is not.

Net operating margin equals 11% for both companies. The difference between the two margin ratios are selling costs and administrative and general overhead. It suggests that selling costs and additional overhead are much larger for Gunge than for Guntzel. Higher selling costs and overhead is consistent with a policy of offering more facilities for customers and higher service levels (larger and better equipped showrooms, more sales agents, a more extensive network of sales outlets, etc.).

Although Credit given is significantly different for the two companies, credit obtained is not. Gunge takes 50 days to pay its suppliers, whereas Guntzel takes 47 days. Relating credit obtained and credit given for both companies points to important differences in net working capital needs. Guntzel finances a larger part of its gross working capital by supplier credit. Taking into account the higher inventory levels at Gunge, we can conclude that financing needs of net working capital are significantly larger for Gunge than for Guntzel. Higher net working capital increases the current ratio of Gunge, while it seems to negatively affect its ROCE (higher amount of capital employed).

The low level of days inventory outstanding and the low level of credit given (reducing the level of inventory and trade receivables as current assets) is consist with a low-cost company profile.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.7 Solution - Black Forest Supermarkets (1)

Ratios: 20X6

20X5

20X4

1.27% 3.62% 3.90% 0.0258 26.02% 9.83% 0.84%

0.33% 2.63% 2.78% 0.0067 27.99% 8.50% 0.27%

4.87% 4.62% 4.87% 0.0975 31.04% 11.08% 7.12%

0.53 0.56 9.03 96.68

0.44 0.47 8.44 71.12

0.65 0.71 10.79 56.66

163.87% 62.10% 1.15

165.98% 62.40% 1.05

0.00% 0.00% 0.00

0.79 0.21 40.42 3.78 68.76

0.97 0.27 43.27 5.13 61.26

1.59 0.78 33.83 6.44 41.88

Management performance ratios A. Profitability ratios ROE ROA ROCE EPS Gross operating margin Net operating margin Net profit margin B. Asset utilization ratios Total asset turnover Long-term asset turnover Inventory turnover Receivables turnover

Financial strength ratios A. Long-term solvency risk ratios Gearing Gearing (Total finance) Interest cover B. Short-term liquidity ratios Current ratio Acid test ratio Days inventory outstanding Credit given Credit obtained

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.7 Solution - Black Forest Supermarkets (2)

Solutions steps: First have a look at the balance sheet and P/L statement over time. Any significant trends? 

At a minimum: Sales / Assets / Equity / Liabilities / Profit

Consider Common-size financial statement and Time indices.

This would provide a view on changes in the structure of the balance sheet and P/L statement.

Next step: Assess the consequences of this on Management performance and Financial strength? 

Assess ratios individually and in a time series mode



Interpret within business context



Interrelate ratios

First observations: 1) Sales   

Fast growth Major growth in 20X5 Still additional growth in 20X6

2) Assets 

Fast growth in 20X5, not in 20X6

3) Equity 

No substantial increase

4) Liabilities 

Huge increase in 20X5

5) Profit 

Decrease!?? – To be explained

Core issue: Considerable growth (sales, assets), but dramatic decrease of bottom line (net profit) There are indications that Black Forest has undertaken a major expansion in 20X5, probably by acquiring another company. How do we figure that out?

-

Intangible (Trade mark, Goodwill) appears on balance sheet in 20X5 AND

-

All other assets (including Working capital) expand proportionally

-

This goes together with considerable new debt – the acquisition is financed by debt, not by issuing more shares

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.7 Solution - Black Forest Supermarkets (3)

Effect on ratios: 20X5: 1. Significant dilution of margins 2. Significant dilution of returns  Shareholders‟ return near to ZERO 3. Efficiency in use of assets deteriorates 4. Solvency: Company has become highly geared  High financial risk 5. Liquidity: Current ratio going the wrong way (<1) Relationship with „Credit obtained‟

20X6: 1. Growing sales on same asset base  Organic growth 2. Profitability improves (except…)

3. Gross margin is still decreasing 4. Efficiency in use of assets improves 5. Liquidity worsens  Current ratio/ Acid test /Credit obtained 6. Considerable interest charge

Interpretation of ratios: 1) Gross margin decline in 20X6  Relationship with growth in 20X6?  Gross margin = [Sales – COS] / Sales  How can it decline?

[Volume effect is eliminated in ratio measurement]  Lower sales price per unit  Higher cost per unit  Attracting sales by lowering sales price per unit?

2) Net operating margin increase in 20X6  Stable selling and administrative overhead on growing sales 3) Effect of growth on net profit margin in 20X6  Not really significant  = Full effect of gearing 4) Liquidity declines further in 20X6  Interest payments and net working capital needs  Relationship with suppliers may become dangerous

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.7 Solution - Black Forest Supermarkets (4)

5) Credit given low; Receivables turnover high  Retail business 6) Efficiency ratios (asset utilisation ratios)  20X5: Acquisition has negative effect and needs time  20X6: Efficiency increase through organic growth  Same assets generating more sales in 20X6 (more output on same input) 7) Comparing ROE and ROA  Effect of interest expense

Conclusion: In headline terms, Black Forest has undertaken a major expansion in 20X5, probably by acquisition of another company (all asset categories increase considerably, and a major intangible appears in the statement of financial position in 20X5, suggesting an acquisition).

This has caused it to acquire significant debt and has caused dilution of margins.

Asset utilisation ratios signal less efficient use of assets in 20X5, probably due to post-acquisition inefficiencies and maybe a high takeover price. Asset efficiency gets better in 20X6 as the company keeps growing from a constant assets base (organic growth versus acquired growth).

The signs are that Black Forest has taken steps to improve profits in the combined group and sales are continuing to expand, increasing from 2,987 in 20X5 to 3,674 in 20X6 on the same asset base (organic growth).

It appears that gross margin has been sacrificed to achieve higher sales, with this dropping from 28% in 20X5 to 26% in 20X6 (you may which to elaborate on alternative causes of a change in gross operating margin).

Nonetheless, the debt has changed Black Forest from an all-equity balance sheet to a gearing of 62%, and a statement of profit or loss burdened by an interest charge of 315 in 20X6 (you may wish to elaborate on the issue of financial leverage and on the effect of variable versus fixed interest rates).

It looks probable that Black Forest will trade out of the present situation, but it is highly vulnerable to interest rate increases in its present highly geared structure.

Without further equity finance it will not be able to expand for some time, and present returns to shareholders are minimal.

The company has gone from a small, profitable and low risk operation to a higher, less profitable, more risky business. This initiative may well prove worthwhile in a few years but is not satisfactory for shareholders in the short term

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (1)

Ratios: 20X3

20X4

20X5

16.10% 9.88% 10.97% 0.38 65.00% 20.11% 7.82%

10.16% 8.99% 9.94% 0.24 63.01% 17.68% 4.82%

-0.59% 5.92% 6.95% -0.01 61.00% 10.89% -0.25%

0.72 0.90 1.43 103.40

0.74 0.93 1.46 98.56

0.73 0.94 1.31 102.39

1.57 0.61 2.39

1.58 0.61 1.69

1.77 0.64 0.97

2.00 0.23 254.60 3.53 103.15

2.12 0.17 249.46 3.70 104.54

1.52 0.05 278.09 3.56 147.80

Management Performance ratios

A. Profitability ratios ROE ROA ROCE EPS Gross operating margin Net operating margin Net profit margin B. Asset utilization ratios Total asset turnover Long-term asset turnover Inventory turnover Receivables turnover

Financial strength ratios

A. Long-term solvency risk ratios Gearing Gearing (Total finance) Interest cover B. Short-term liquidity ratios Current ratio Acid test ratio Days inventory outstanding Credit given Credit obtained

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (2)

Solution steps: 1) Look at key items of financial statements over time 

At a minimum: Sales / Assets / Equity / Liabilities / Profit



Helpful: Common-size financial statements and Time indices



Check presence of new items or extraordinary change in items

2) Assess consequences for Management performance and Financial position 

Assess ratios individually and in a time series mode



Interpret within business context



Interrelate ratios

First observations: 1) Sales 

No significant change over time

2) Assets  Asset base is stable  Total assets / Non-current assets / Depreciation 3) Equity / Liabilities  Minor decrease in equity in 20X5 4) Profit  

Steadily declining Becomes negative in 20X5

5) Bank overdraft  No cash asset in 20X5  Negative cash Depreciation: Causes a ‘natural’ decline in non-current assets Bank overdraft: Is usually quite expensive!

Core issue: Stable sales and assets, but a cash drain! Combined, this leads to a loss situation without signs of a turnaround.

A statement of cash flows would be helpful to figure out where the cash drain comes from, but unfortunately is not available.

Looking at the raw data, it becomes already clear that the company is sliding backwards and is in need of management attention.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (3)

Effect on ratios: 1) Profitability  Declining, without reversal  Trend of ROE!  2) Asset utilisation  No significant changes  The use of assets is not problematic (same assets, same revenue) 3) Short-term liquidity  Current ratio versus acid-test ratio  Credit obtained increases  Negative cash 4) Long-term solvency  Relatively high gearing  Interest cover < 1 ROE: Goes from a healthy 16.1% to (0.6) % Current ratio does not seem alarming (from 2.0 to 1.5), but Acid test is more indicative of liquidity because of large inventory in Clothing retailing.

Leads our attention to Bank overdraft (expensive!)

Gearing: Relatively high, but quite stable Interest cover: Points to the importance of the impact of interest charges.

Interpretation of ratios 1) Gross operating margin  65% and declining  Type of business  Relate to inventory turnover  Compare with supermarket case 2) Why does the GOM decrease?  Selling price per unit? and/or  Cost per unit?

3) GOM - Net operating margin - Net profit margin  Administrative and selling costs are increasing  Interest charges 4) Interest expense and Interest cover  Interpret change in time 5) Days inventory outstanding and Credit obtained  Increase of inventory financed by suppliers  Relationship with suppliers becomes problematic 6) Compare trend of ROE and ROA / ROCE  Higher relative decline of ROE  But ROA and ROCE go down as well  ROE < ROCE: Indicative of negative financial leverage

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (4)

What causes the cash drain?

1) Cash flow statement would have been very helpful here!

2) Business reasons for a cash drain?

a) High capital expenditure (investing is assets) b) Repayment of debt c) Operations that burn cash (large losses) d) ....??

3) Key = Relationship between Net profit and Equity 

Check whether „Increase in equity‟ corresponds with „Net profit of period‟  20X4: (1) versus 29  20X5: (31.5) versus (1.5)



Difference of (30) through Retained earnings



Constant dividend payment in time of 30

Conclusion: This company is sliding backwards and is in need of management attention.

Its sales and asset base are stable, but its profits are declining. There seems to be an important cash flow or liquidity problem as the balance sheet shows a bank overdraft in 20X5 (negative cash). This is probably an expensive source of finance.

The return on equity has declined from 16.1% in 20X3 to being negative in 20X5, and all other profitability ratios are declining.

Short-term borrowing has turned its current ratio from 2.0 to 1.5 over the same period (but the acid test ratio may be conceived as even more informative in this respect, given the high average level of inventory and related slow inventory turnover).

The company‟s problems stem from two areas: rising interest expense and rising operating expense.

The interest charge has risen from 49.5 in 20X3 to 63.0 in 20X4, on the same borrowings (same level of long-term debt), and to 72.0 in 20X5 when there are additional short-term borrowings (probably more expensive than the long-term financing). This is a major factor in the loss of (net) profitability and demonstrates the problems of interest rate exposure for a highly geared company (gearing is over 60%).

Interest cover goes below 1 in 20X5– related to the net loss in 20X5.

At the same time, the gross operating margin has declined, dropping from 65% to 61% over the three years. This may be due to higher supply prices (purchase price as unit cost of goods sold), or to a reduction in selling prices to retain sales in a competitive market (you may insist on the industry-specific nature of the level of the gross operating margin and on its link with inventory turnover).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (5) The liquidity problem will probably affect relations with suppliers as well. Credit obtained goes from 103 to 148 days, not making suppliers very happy. This could in part explain the declining gross operating margin, as suppliers could be increasing their supply prices to compensate the delay in getting payment.

At the same time, the company has not been able to control its distribution and administration expenses (relate change in gross operating margin and change in net operating margin), although the 20X5 rise in the former may be to do with increased advertising.

Overall it is understandable that the company would like to replace some or all of its debt with equity, since the cancellation of interest charges would see an immediate return to profit.

However, discussions with management are necessary to discuss the growth of operational costs and the relatively stagnant level of sales. It should also be noted that the company appears to be paying its shareholders a dividend of 30 a year (based on the variation in equity after taking account of profit of the period) even when there is no profit (let students look for the main source of the cash drain (in the event of dividend payment)), is an opportunity to elaborate on the link between the statement of financial position (equity) and the statement of profit or loss and to set the pace for the relevance of a statement of cash flows).

You may also wish to elaborate on the relationship between level and change in ROE and ROCE and relate this to the cost of debt (net of tax) and the notion of financial leverage:

Compare Return of investment (ROCE/ROA) and net cost of debt:

ROA

ROCE

Interest rate (after tax)

20X3

9.88%

10.97%

?

20X4

8.99%

9.94%

?

20X5

5.92%

6.95%

?

Tax rate = 30% ROA (20X5) = [-1.5 + (72.0 x (1-0.3))] / 826,2 = 5,92% (including the bank overdraft)

Interest expense rate (after tax) = (Interest expense / Interest-bearing liabilities) x (1 – Tax rate) 20X3

49.5/450 (=11%) x 0.7 = 7.7%

20X4

63/450 (= 14%) x 0.7 = 9.8%

20X5

72/476,9 (= 15.1%) x 0.7 = 10.57%

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.8 Solution - Clothing Retailer (6)

ROA

ROCE

Interest expense (after tax)

20X3

9.88%

10.97%

7.7%

20X4

8.99%

9.94%

9.8%

20X5

5.92%

6.95%

10.6%

Going from a situation of positive financial leverage in 20X3 to a situation of negative financial leverage in 20X5.

Reducing debt and renegotiating debt terms will be beneficial for shareholder returns (ROE).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

9.9 Solution – Who is who?

A

B

C

D

E

F

Debt/equity ratio

0.21

0.90

1.52

3.46

0.26

1.74

Current ratio

2.76

0.95

1.06

1.38

0.63

0.91

Acid test ratio

2.57

0.90

0.39

0.58

0.63

0.86

Inventory turnover

25.12

63.39

11.73

3.33

n.a.

185.32

Credit given

70.00

79.00

8.00

38.00

73.00

3.00

Asset turnover

0.94

0.87

2.35

0.97

0.01

3.25

Return on equity

0.11

0.05

0.04

0.01

0.16

0.02

A = brewery B = publisher of weekly magazines C = supermarket chain D = steel company E = venture capital company F = restaurant chain

Issues: - This puzzle highlights the relevance of ratios using current assets and current liabilities (working capital ratios) to distinguish between industries/businesses.

- Return on equity and gearing are less useful in solving this assignment.

- First let students look at the ratios with the larger differences between companies (credit given and inventory turnover) and let them reason about the underlying business.

- Inventory turnover „not applicable‟ may mean no inventory or no sales (the latter is probable for a venture capital company).

- Compare current ratio and acid test ratio to get a hint of the level of inventory.

- Inventory turnover is useful for identifying restaurant chain, steel company (high level of production chain inventories) and publisher.

- Credit given is useful for identifying restaurant chain and supermarket chain.

- Asset turnover can be used to talk about capital intensity.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

10.1 Solution – Seurat AG – Preparing a statement of cash flows (1)

1.1.20X1

31.12.20X1

Outflow

Inflow

PP&E Acc. depreciation Inventory Receivables Cash

5,000 1,200 1,800

5,000 (1,000) 1,800 2,300 4,300

600 2,300 2,500

Share capital Retained profit Trade payables

8,000 -

8,000 3,000 1,400

-

3,000 1,400

5,400

5,400

1,000

Net incoming cash flow of the year amounts to €2,500 (Cash increases from €1,800 to €4,300).

Reconciliation:

Accounting profit

3,000

Add back Depreciation expense

+1,000

Non-cash working capital movements: Increase Inventory Increase Receivables Increase Trade payables

-600 -2,300 +1,400

Net cash from operations

2,500

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

10.2 Solution – Seurat AG – Preparing a statement of cash flows (2)

31.12.20X1

31.12.20X2

Outflow

PP&E Acc. depreciation Inventory Receivables Cash

5,000 (1,000) 1,800 2,300 4,300

13,000 (2,800) 4,400 2,900 11,900

8,000

Share capital Retained profit LT Borrowing Taxes payable Trade payables

8,000 3,000 1,400

8,000 10,200 5,000 3,000 3,200

Inflow

1,800 2,600 600 7,600

7,200 5,000 3,000 1,800 18,800

Seurat AG Statement of Cash Flows for the year ended 31st. December, 20X2 Operations Net profit Add back Depreciation expense Non-cash working capital movements: Increase in Inventory Increase in Receivables Increase in Trade payables and Taxes payable

-2,600 -600 +4,800

Net cash from operating activities

+10,600

7,200 1,800

Investing Purchase of Plant

-8,000

Financing LT Borrowing

+5,000

Net cash movement

+7,600

Bank balance at start Bank balance at close

4,300 11,900

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

18,800

10.3 Solution – Seurat AG – Preparing a statement of cash flows (3) 31.12.20X2

31.12.20X3

Change

Outflow

PP&E Acc. depreciation Inventory Receivables Cash

13,000 (2,800) 4,400 2,900 11,900

23,000 (3,100) 4,800 3,200 7,400

10,000 300 400 300 4,500

15,000 2,000 400 300

Share capital Retained profit

8,000 10,200

8,000 18,980

8,780

2,000

LT Borrowing Trade payables Taxes payable

5,000 3,200 3,000

3,700 4,620

5,000 500 1,620

5,000

5,000 2,300

4,500

10,780

500 1,620 24,700

Seurat AG Statement of Cash Flows for the year ended 31st. December, 20X3 Operations Net profit after tax Add back Depreciation expense Deduct Gain on asset disposal Non-cash working capital movements:

Inflow

10,780 2,300 -500

Increase in Inventory Increase in Receivables Increase in Trade payables and Taxes payable

-400 -300 +2,120

Net cash flow from operating activities

+14,000

Investing Purchase of Plant Sale of Plant

-15,000 +3,500

Net cash flow from investing activities

-11,500

Financing Repayment of LT Borrowing Payment of dividend

-5,000 -2,000

Net cash flow from financing activities

-7,000

Net cash flow for the year Bank balance at start Bank balance at close

-4,500 11,900 7,400

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

24,700

10.4 Solution - Preparing a statement of cash flows

31.12.20X6

31.12.20X7

Change

Outflow

Property at valuation Plant & Equipment Acc. depreciation

2,350 980 -423

3,850 1,560 -572

1,500 580 149

1,000 580

Inventories Receivables Cash

841 1,213 106

923 1,297 73

82 84 33

82 84

430 802 435 551

460 892 935 771

30 90 500 220

1,200 1,432 217

2,200 1,675 198

1,000 243 19

Share capital Share premium Revaluation reserve Retained profit LT Creditors Trade payables Taxes payable

Statement of Cash Flows for the year ended 31st. December, 20X7 Operations Net profit Add back Depreciation expense

325 +149

Non-cash working capital movements: Increase in Inventory Increase in Receivables Increase in Current liabilities

-82 -84 +224

Cash flow from operating activities

+532

Investing Purchase of long-term assets

-1,580

Cash flow from investing activities

-1,580

Financing Shares subscribed Borrowing Dividends paid

+120 +1,000 -105

Cash flow from financing activities

+1,015

Net cash flow for the year

-33

Bank balance at start Bank balance at close

106 73

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

Inflow

149

33 30 90 105

325 1,000 243

19

12.1 Solution – Dickens Enterprises

Consolidated Statement of Financial Position of Dickens Enterprises at 31 December 20X4

Dickens

GE

Adjustments

Group

Assets PP&E (net) Investment in GE Inventories Trade receivables Cash

5,200 500 700 800 1,200

750

Totals

8,400

884

-500

8,784

Share capital Retained earnings Profit for 20X4 Sub-total Equity

3,000 1,900 700 5,600

500 31 531

-500

3,000 1,900 731 5,631

LT Borrowings ST Liabilities

1,000 1,800

300 53

Totals

8,400

884

-500 49 60 25

5,950 749 860 1,225

Equity/Liabilities

-500

1,300 1,853 -500

8,784

Elaborate on the difference between a subsidiary founded by the parent company and a subsidiary acquired from third parties in relation to the notion of goodwill.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.2 Solution – Alfa Company

Alfa Company with new subsidiary (distribution by mail order)

Consolidated Statement of Financial Position of Alfa Company at 31 December 20X6

Parent

Subsidiary

Adjustments

Group

980 180 50 360

340

1,570

535

-230

1,875

Share Capital Retained earnings Sub-total equity

800 360 1,160

180

-180

180

-180

800 360 1,160

Loan from parent LT Borrowings Current liabilities

50 250 55

-50

300 110 1,570

535

-230

Assets PP&E (net) Investment in Subsidiary Loan to Subsidiary Current assets Totals

1,320 -180 -50

195

555

Equity/Liabilities

Totals

550 165

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

1,875

12.3 Solution – Earduster Company (1)

Consolidated Statement of Financial Position:

Full consolidation

Proportionate consolidation

Equity method

Property, plant and equipment (net) Investment in Talebearer Other financial assets Inventories Trade receivables

4,400,000 100,000 3,150,000 1,300,000

4,250,000 100,000 2,700,000 1,100,000

4,100,000 280,000 100,000 2,250,000 900,000

Total assets

8,950,000

8,150,000

7,630,000

2,000,000 2,000,000

2,000,000 2,000,000

2,000,000 2.000,000

430,000 280,000

430,000 -

430,000 -

Liabilities Trade payables Other payables Short-term debt

2,740,000 1,100,000 400,000

2,520,000 1,000,000 200,000

2,300,000 900,000 -

Total equity and liabilities

8,950,000

8,150,000

7,630,000

Assets

Financing Equity Share capital Retained earnings Profit for the year (Equity holders of parent) Non-controlling interest

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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12.3 Solution – Earduster Company (2)

Consolidated Statement of Profit or Loss:

Full consolidation

Proportionate consolidation

Equity method

Revenue Cost of sales Gross profit

14,600,000 -13,000,000 1,600,000

12,800.000 -11,500,000 1,300,000

11,000.000 -10,000,000 1,000,000

Other operating income Other operating expenses

1,300,000 -2,440,000

1,150,000 -2,020,000

1,000,000 -1,600,000

-

-

30,000

Profit for the period

460,000

430,000

430,000

Attributable to: Equity holders of the parent Non-controlling interest

430,000 30,000

430,000 -

430,000 -

Share of profit of associates

Notes: > Method used has no effect on Equity (excluding non-controlling interest) and on profit for the period (attributable to equity holders of the parent). > Totals of assets and liabilities are affected.

Thus, the method used will have an impact on ratios which involve assets or liabilities.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.4 Solution – Omega Company (1)

(a) Consolidated Statement of Financial Position of Omega Company at acquisition date

PP&E (net) Goodwill Investment in Beta Other financial assets

Omega

Beta

1,500,000

880,000

Adjustments

Group 2,380,000 236,800 0 50,000 1,420,000 790,000

1,000,000 50,000

160,000

236,800 -1,000,000 -160,000

Inventories Trade receivables

900,000 650,000

520,000 240,000

-100,000

Cash

263,200

48,000

Total assets

4,363,200

1,848,000

-1,023,200

5,188,000

Share capital Retained earnings

2,000,000 563.200

800,000 48,000

-800,000 -48,000

2,000,000 563,200

Non-controlling interest Long-term debt

1,000,000

600,000

84,800 -160,000

84,800 1,440,000

800,000

400,000

-100,000

1,100,000

4,363,200

1,848,000

-1,023,200

5,188,000

Current payables Total equity and liabilities

311,200

Goodwill calculation: Acquisition cost of investment:

1,000,000

Equity value of investment: Share capital Retained earnings

800,000 48,000 848,000 @ 90%:

-763,200 236,800

 goodwill

The investment represents 90% of the shares of Beta  non-controlling interest = 84,800

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.4 Solution Omega Company (2)

(b) Consolidated Statement of Financial Position of Omega Company at acquisition date with fair value adjustments

Omega

Beta

Adjustments

Group

1,500,000

880,000

1,000,000 50,000

160,000

100,000 (1) 146,800(2) -1,000,000(2) -160,000

2,480,000 146,800 0 50,000

900,000 650,000 263,200

520,000 240,000 48,000

-100,000

1,420,000 790,000 311,200

Total assets

4,363,200

1,848,000

-1,013,200

5,198,000

Share capital Retained earnings

2,000,000 563,200

800,000 48,000

-800,000 -48,000

2,000,000 563,200

PP&E (net) Goodwill Investment in Beta Other financial assets Inventories Trade receivables Cash

Fair value reserve

100,000 (1) -100,000 (2)

Non-controlling interest Long-term debt Current payables Total equity and liabilities

1,000,000

600,000

94,800 (2) -160,000

800,000

400,000

-100,000

1,100,000

4,363,200

1,848,000

-1,013,200

5,198,000

(1) Fair value adjustment of PP&E in Beta‟s equity (2) Elimination of re-valued equity of Beta Goodwill calculation: Acquisition cost of investment:

1,000,000

Equity value of investment: Share capital Retained earnings

800,000 48,000 848,000 @ 90%:

Fair value adjustments: Property, plant & equipment: @ 90%:

-763,200 236,800 100,000 -90,000 146,800

 goodwill The investment represents 90% of the shares of Beta  non-controlling interest = 94,800

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

94,800 1,440,000

12.5 Solution – Invigilator Enterprises (1)

Question (a): Goodwill calculation:

Acquisition cost of investment: Equity value of investment:

600,000

Share capital Retained earnings

200,000 100,000 300,000 @ 100%:

-300,000 300,000

Fair value adjustments: Property, plant & equipment: Intangible asset: Inventory:

80,000 80,000 -40,000 120,000

@ 100%:

-120,000 180,000

 goodwill

The investment represents 100% of the shares of Lemma  no non-controlling interest

Consolidation adjustments: Goodwill at acquisition date:       

+

Intangibles (patent) (A ) + Goodwill (A ) + PP&E (A ) Inventories (A ) Share capital (E ) Retained earnings (E ) Investment in Lemma (A )

+80,000 +180,000 +80,000 - 40,000 -200,000 -100,000 - 600,000

Intra-group balances at acquisition date:  

-

Trade receivables (A ) Current liabilities (L )

-100,000 -100,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.5 Solution – Invigilator Enterprises (2)

Consolidated Statement of Financial Position of Invigilator Enterprises at 01/01/20X5:

Consolidated Statement of Financial Position Invigilator

Lemma

Adjust.

Group

490,000 600,000 230,000 400,000

2,000 80,000 360,000 240,000

80,000 180,000 80,000 -600,000 -40,000 -100,000

82,000 180,000 650,000 0 550,000 540,000

1,720,000

682,000

-400,000

2,002,000

Share capital Retained earnings

1,000,000 140,000

200,000 100,000

-200,000 -100,000

1,000,000 140,000

Provisions Current liabilities

20,000 560,000

30,000 352,000

-100,000

50,000 812,000

1,720,000

682,000

-400,000

2,002,000

Assets Intangible assets Goodwill Property, plant and equipment (net) Investment in Lemma Inventories Trade and other receivables Total assets Financing

Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.5 Solution – Invigilator Enterprises (3)

Question (b): Goodwill calculation:

Acquisition cost of investment:

600,000

Equity value of investment: Share capital Retained earnings

200,000 100,000 300,000 @ 90%:

-270,000 330,000

Fair value adjustments: Property, plant & equipment: Intangible asset: Inventory:

80,000 80,000 -40,000 120,000

@ 90%:

-108,000 222,000

 goodwill

The investment represents 90% of the shares of Lemma  Non-controlling interest = 10% of (300,000+120,000) = 42,000

Consolidation adjustments: a. Goodwill at acquisition date:        

+

Intangibles (patent) (A ) + Goodwill (A ) + PP&E (A ) Inventories (A ) Share capital (E ) Retained earnings (E ) Investment in Lemma (A ) + Non-controlling interest (E )

+80,000 +222,000 +80,000 - 40,000 -200,000 -100,000 - 600,000 +42,000

b. Intra-group balances at acquisition date:  

-

Trade receivables (A ) Current liabilities (L )

-100,000 -100,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.5 Solution – Invigilator Enterprises (4) Consolidated Statement of Financial Position of Invigilator Enterprises at 01/01/20X5:

Consolidated Statement of Financial Position Invigilator

Lemma

Adjust.

Group

490,000 600,000 230,000 400,000

2,000 80,000 360,000 240,000

80,000 222,000 80,000 -600,000 -40,000 -100,000

82,000 222,000 650,000 0 550,000 540,000

1,720,000

682,000

-358,000

2,044,000

1,000,000 140,000 -

200,000 100,000 -

-200,000 -100,000 42,000

1,000,000 140,000 42,000

20,000 560,000

30,000 352,000

-100,000

50,000 812,000

1,720,000

682,000

-358,000

2,044,000

Assets Intangible assets Goodwill Property, plant and equipment (net) Investment in Lemma Inventories Trade and other receivables Total assets Financing Share capital Retained earnings Non-controlling interest Provisions Current liabilities Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.6 Solution – Dabster Company (1)

Question (a): Goodwill calculation: Acquisition cost of the investment:

800,000

Equity value of investment: Share capital Retained earnings Interim profit

400,000 300,000 40,000 740,000 @ 100%:

-740,000 60,000

Fair value adjustments: Property, plant & equipment:

50,000

@ 100%:

-50,000 10,000

 goodwill

The investment represents 100% of the shares of Saltus:  No non-controlling interest

Consolidation adjustments: (1) Goodwill at acquisition date: + Goodwill (A ) + PP&E (A ) Share capital (E ) Retained earnings (E ) Profit for the year (E ) Investment in Saltus (A )

+10,000 +50,000 -400,000 -300,000 -40,000 -800,000

(2) Impairment of goodwill at year end: Goodwill (A ) Profit for the year (E )

-1,000 -1,000

(3) Depreciation of fair value adjustment in PP&E: PP&E (A ) Profit for the year (E )

-1,250 -1,250

(4) Inventory adjustment (profit on intra-group transaction): Inventories (A ) -12,500 Profit for the year (E ) -12,500

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.6 Solution – Dabster Company (2)

Consolidated Statement of Financial Position of Dabster Company at 31/13/20X4:

Consolidated Statement of Financial Position

Dabster

Saltus

Adjust.

Group

1,550,000 800,000 300,000 150,000 50,000

500,000 200,000 200,000 100,000

9,000 48,750 -800,000 -12,500 -

9,000 2,098,750 0 487,500 350,000 150,000

2,850,000

1,000,000

-754,750

3,095,250

1,500,000 500,000 100,000 -

400,000 300,000 100,000 -

-400,000 -300,000

1,500,000 500,000 145,250

750,000

200,000

-

950,000

2,850,000

1,000,000

-754,750

3,095,250

Assets Goodwill Property, plant and equipment (net) Investment in Saltus Inventories Trade and other receivables Cash and cash equivalents

(1),(2) (1),(3) (4)

Total assets Financing Share capital Retained earnings Profit for the year Profit adjustment on sales Depreciation building (FV adjustment) Impairment of goodwill Pre-acquisition profit Current liabilities Total equity and liabilities

(1) (1) (4) (3) (2) (1)

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-12,500 -1,250 -1,000 -40,000

12.6 Solution – Dabster Company (3)

Question (b): Goodwill calculation: Acquisition cost of investment:

800,000

Equity value of investment: Share capital Retained earnings Interim profit

400,000 300,000 40,000 740,000 @ 80%:

-592,000 208,000

Fair value adjustments: Property, plant & equipment: 50,000 @ 80%:

-40,000 168,000

 goodwill

The investment represents 80% of the shares of Saltus:  Non-controlling interest (NCI) = 20% of (740,000+50,000) = 158,000 Consolidation adjustments: (1) Goodwill at acquisition date: + Goodwill (A ) + PP&E (A ) Share capital (E ) Retained earnings (E ) Profit for the year (E ) + Non-controlling interest (E ) Investment in Saltus (A )

+168,000 +50,000 -400,000 -300,000 -40,000 +158,000 - 800,000

(2) Impairment of goodwill at year end: Goodwill (A ) Profit for the year (E )

-16,800 -16,800

(3) Depreciation of fair value adjustment in PP&E: PP&E (A ) Profit for the year (E )

-1,250 -1,250

(4) Inventory adjustment (profit on intra-group transaction): Inventories (A ) -12,500 Profit for the year (E ) -12,500 No effect on non-controlling interest as intra-group profit is derecognized in income statement of parent.

(5) Part of non-controlling interest (NCI) in group profit:  20% of (60,000 – depreciation fair value adjustment) = 11,750

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.6 Solution – Dabster Company (4)

Consolidated Statement of Financial Position of Dabster Company at 31/12/20X4:

Consolidated Statement of Financial Position Dabster

Saltus

Adjust.

Group

1,550,000 800,000 300,000 150,000 50,000

500,000 200,000 200,000 100,000

151,200 48,750 -800,000 -12,500 -

151,200 2,098,750 0 487,500 350,000 150,000

2,850,000

1,000,000

-612,550

3,237,450

(1) (1)

1,500,000 500,000

400,000 300,000

-400,000 -300,000

1,500,000 500,000

100,000 -

100,000 -

-12,500 -1,250 -16,800 -40,000 -11,750

117,700

(4) (3) (2) (1) (5) (1) (5)

-

-

158,000 11,750

158,000 11,750

750,000

200,000

-

950,000

2,850,000

1,000,000

-612,550

3,237,450

Assets Goodwill Property, plant and equipment (net) Investment in Saltus Inventories Trade and other receivables Cash and cash equivalents

(1),(2) (1),(3) (4)

Total assets Financing Share capital Retained earnings Profit for the year Equity holders of the parent Profit adjustment on sales Depreciation building Impairment of goodwill Pre-acquisition profit Post-acquisition profit/NCI Non-controlling Interest (NCI) At acquisition date Post-acquisition profit Current liabilities Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

12.6 Solution – Dabster Company (5)

Question (c) – Applying the full goodwill method

First, we have to estimate the fair value of the 20% non-controlling interest (NCI) at acquisition date.

To simplify, we set this value equal to one fourth of the acquisition cost of the majority interest of 80% (assuming no control premium).

Goodwill calculation (full goodwill method):

Acquisition cost of investment + Fair value of NCI: 1,000,000 Equity value of investment: Share capital Retained earnings Interim profit

400,000 300,000 40,000 740,000 @ 100%:

-740,000 260,000

Fair value adjustments: Property, plant & equipment: 50,000 @ 100%:

-50,000 210,000

* The non-controlling interest (NCI) at acquisition date represents 20% of Saltus: 20% (1,000,000) or 20% (740,000 + 50,000 + 210,000) = 200,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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12.6 Solution – Dabster Company (6)

Consolidation adjustments: (1)

Goodwill at acquisition date: +

Goodwill (A ) + PP&E (A ) Share capital (E ) Retained earnings (E ) Profit for the year (E ) + Non-controlling interest (E ) Investment in Saltus (A )

(2)

Impairment of goodwill at year end: -

Goodwill (A ) Profit for the year (E ) (3)

-21,000 -21,000

Depreciation of fair value adjustment in PP&E: -

PP&E (A ) Profit for the year (E ) (4)

+210,000 +50,000 -400,000 -300,000 -40,000 +200,000 - 800,000

-1,250 -1,250

Inventory adjustment (profit on intra-group transaction): -

Inventories (A ) Profit for the year (E )

-12,500 -12,500

No effect on non-controlling interest (NCI) as intra-group profit is derecognized in income statement of parent.

(5)

Part of non-controlling interest (NCI) in group profit:  20% of (60,000 – impairment of goodwill – depreciation of fair value adjustment) = 7,550

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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12.6 Solution – Dabster Company (7)

Consolidated Statement of Financial Position of Dabster Company at 31/12/20X4:

Consolidated Statement of Financial Position Dabster

Saltus

Adjust.

Group

1,550,000 800,000 300,000 150,000 50,000

500,000 200,000 200,000 100,000

189,000 48,750 -800,000 -12,500 -

189,000 2,098,750 0 487,500 350,000 150,000

2,850,000

1,000,000

-574,750

3,275,250

(1) (1)

1,500,000 500,000

400,000 300,000

-400,000 -300,000

1,500,000 500,000

100,000 -

100,000 -

-12,500 -1,250 -21,000 -40,000 -7,550

117,700

(4) (3) (2) (1) (5) (1) (5)

-

-

200,000 7,550

200,000 7,550

750,000

200,000

-

950,000

2,850,000

1,000,000

-574,750

3,275,250

Assets Goodwill Property, plant and equipment (net) Investment in Saltus Inventories Trade and other receivables Cash and cash equivalents

(1),(2) (1),(3) (4)

Total assets Financing Share capital Retained earnings Profit for the year Equity holders of the parent Profit adjustment on sales Depreciation building Impairment of goodwill Pre-acquisition profit Post-acquisition profit/NCI Non-controlling Interest (NCI) At acquisition date Post-acquisition profit Current liabilities Total equity and liabilities

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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12.7 Solution – Wearside Products PLC (1)

(a) 100% acquisition

Wear

NE

Acquisition

Adjustments

Cash

Group

Assets Non-current assets Intangible (other) Goodwill Tangible assets Investments

200.1

-

200.1 40.3 247.3 10.5

40.3 180.2

67.1 10.5

Current assets Inventories Receivables Cash

37.4 41.8 5.9

20.2 19.3 39.2

Total assets

465.4

156.3

144.0

144.0

-144.0

-103.7

-36.0

57.6 61.1 9.1

-36.0

626.0

Financing Ordinary shares (€1) Share premium Retained earnings

68.5

24.0

123.9

79.7

Sub-total equity

192.4

103.7

108.0

Current liabilities

48.3

21.6

36.0

Non-current liabilities

224.7

31.0

Total equity & liabilities

465.4

156.3

24.0 84.0

-24.0

92.5 84.0 123.9

-79.7 -103.7

-

300.4

-36.0

69.9 255.7

144.0

-103.7

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

-36.0

626.0

12.7 Solution – Wearside Products PLC (2)

Consolidated Statements of Financial Position

(a) (i) Goodwill capitalised

(a) (ii) Brand recognized

(a) (iii) Brand + FV adjustment

200.1 40.3 247.3 10.5 ----498.2

200.1 0.3 40.0 247.3 10.5 ----498.2

200.1 0.3 20.0 267.3 10.5 ----498.2

Current assets: Inventories Receivables Cash

57.6 61.1 9.1

57.6 61.1 9.1

57.6 61.1 9.1

Total assets

626.0

626.0

626.0

Sub-total equity

92.5 84.0 123.9 ----300.4

92.5 84.0 123.9 ----300.4

92.5 84.0 123.9 ----300.4

Current liabilities Non-current liabilities

69.9 255.7

69.9 255.7

69.9 255.7

Total equity & liabilities

626.0

626.0

626.0

Non-current assets: Intangibles - other - goodwill - brand Tangibles Investments

Equity: Share capital Share premium Retained earnings

Notes The worksheets show how the statements of financial position have been built up. The accounting value of the shares issued by Wearside is a critical issue. Under the acquisition method, they should be valued at “fair value” which is their market value at the time of the acquisition - €4.50. Northeast has 24m shares in issue, so Wearside must issue 24m of its own shares in exchange. These are valued at €1 nominal share value and €3.50 share premium to reflect the €4.50 market value, giving rise to an increase of €24m in share capital and €84m in share premium. Wearside also pays €1.50 cash to Northeast shareholders, and this is simulated as a short term-borrowing, as specified in the question. The total acquisition price would be €144m.

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12.7 Solution – Wearside Products PLC (3)

(b) Non-controlling interest of 40% + partial goodwill method

Wear

NE

200.1

-

Acquisition

Cash

Adjustments

Group

Assets Non-current assets Intangible (other) Goodwill Tangible assets Investments

19.9 180.2

67.1 10.5

Current assets Inventories Receivables Cash

37.4 41.8 5.9

20.2 19.3 39.2

Totals assets

465.4

156.3

82.1

-82.1

200.1 19.9 247.3 10.5

57.6 61.1 27.8

-17.3 82.1

-17.3

-62.2

624.3

Financing Ordinary shares (€1) Share premium Retained earnings Non-controlling interest

68.5

24.0

123.9

79.7

Sub-total equity

192.4

103.7

64.8

Current liabilities

48.3

21.6

17.3

Non-current liabilities

224.7

31.0

Tot equity & liab.

465.4

156.3

14.4 50.4

-24.0 -79.7

82.9 50.4 123.9

41.5

41.5

-62.2

298.7

-17.3

69.9 255.7

82.1

-17.3

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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-62.2

624.3

12.7 Solution – Wearside Products PLC (4)

Consolidated Statement of Financial Position:

(b) Non-controlling interest Non-current assets: Intangibles - other - goodwill Tangibles Investments

200.1 19.9 247.3 10.5 ----477.8

Current assets: Inventories Receivables Cash

57.6 61.1 27.8

Total assets

624.3

Equity: Share capital Share premium Retained earnings

Non-controlling interest Sub-total equity

82.9 50.4 123.9 ----257.2 41.5 298.7

Current liabilities Non-current liabilities

69.9 255.7

Total equity and liabilities

624.3

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12.8 Solution – Traduct SA – Impairment of goodwill

(a) Calculation of the recoverable amount of the Uno CGU: Higher of: Fair value less costs to sell Value in use Recoverable amount

190 228 228

Calculation of impairment loss at CGU level: Carrying value of net assets Less: Recoverable amount = Impairment loss

278 228 50

(b) Allocation of impairment loss: Goodwill Land

Machinery and Equipment Inventory - paper Inventory – other

Reduced to zero No adjustment: Fair value less costs to sell is higher than carrying amount Restated at recoverable amount (18 – 12) Reduced to zero No adjustments – already stated at lower of cost and FVLCS

-25

0 -6 -10

0 Net current assets (other)

No adjustments – already stated at lower of cost and FVLCS

Buildings

Remainder of the impairment loss written-off

0

Impairment loss

-9 50

(c) Adjusted net book values of Uno’s assets:

Goodwill Land Buildings Machinery and Equipment Inventory – paper Inventory – other Net current assets (other than inventory) Total

Initial value €m

Share of impairment loss - €m

Adjusted value €m

25 40 90 18 10 30 65

-25 0 -9 -6 -10 0 0

0 40 81 12 0 30 65

278

-50

228

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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13.1 Solution – Norwood Ltd – Primary FX translation (1)

Norwood Ltd (GB) = Customer ----- Illinois Tools Inc. (US) = Vendor Machine leaves Illinois factory on 1 Oct. 20X1 (1£ = $1.25) Machine reaches customer on 30 Nov. 20X1 (1£ = $1.2) Payments: - 10% or $8,500 on 1 Dec. 20X1 (1£ =$1.20) - 50% or $42,500 on 1 Jan. 20X2 (1£ = $1.15) - 40% or $34,000 on 1 Feb. 20X2 (1£ = $1.10)

(a) Invoice in $: - No exchange rate differences for Illinois Tools - Exchange rate differences for Norwood

Accounting in Norwood's books (£): 30 Nov 20X1

Machine (+) Payables (+)

£70,833 ($85,000/1.2) £70,833

1 Dec 20X1

Cash (-) Payables (-)

£7,083 £7,083 ($ 8,500/1.2)

31 Dec 20X1

Balance creditor (accounts payable): £63,750 ($76,500/1.2) Restatement at closing rate: $76,500/1.15 = £66,522 Payables (+) Expense (exchange rate loss) (+)

1 Jan 20X2

£2,772 £2,772

Payment 50% of $85,000 Cash (-) Payables (-)

£36,957 £36,957

Balance after payment = £29,565 1 Feb 20X2

Payment of balance. (40%): $34,000 at 1.10 Cash (-) Payables (-) Expense (exchange rate loss)(+)

£30,909 £29,565 £1,344

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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13.1 Solution – Norwood Ltd (2)

Impact on Statement of Financial Position at 31/12/20X1: Assets

Equity& Liabilities

Machine Cash

£70,833 £-7,083

Equity (Profit of period) Payables

£-2,772 £66,522

Total

£63,750

Total

£63,750

Impact on Statement of Financial Position at 31/12/20X2: Assets

Equity & Liabilities

Machine Cash

£70,833 £-74,949

Total

£-4,116

Equity (Retained profit/Reserves) Equity (Profit of period) Total

£-2,772 £-1,344 £-4,116

(b)Invoice in £: - No exchange rate differences at Norwood - Exchange rate differences at Illinois Tools

Accounting at Illinois Tools ($) 1 Oct 20X1

Receivable (+) Sales (+)

87,500(70,000 x 1.25) $87,500

1 Dec 20X1 (+ x days)

Cash (+) Receivable (-) Expense (exchange rate loss) (+)

$8,400 (7,000 x 1.2) $8,750 (10% of 87,500) $350

31 Dec 20X1

Balance receivable (accounts receivable) = $78,750 Restatement at closing rate: 63,000 x 1.15 = $72,450 Receivable (-) $6,300 Expense (exchange rate loss) (+) $6,300

1 Jan 20X2 (+ x days)

Receipt 50% of £70,000 Cash (+) Receivable (-)

-

$40,250 (35,000 x 1.15) $40,250

Balance receivable = $32.200 1 Feb 20X2

Balance (40%) received: £28,000 at 1.10 Cash (+) $30,800 (28,000 x 1.1) Receivable (-) $32,200 Expense (exchange rate loss) (+) $1,400

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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13.1 Solution – Norwood Ltd (3)

(a) Asset would enter Norwood's books at £70,883 ($85,000 @ £1 = $1.20) and Illinois would become a creditor for this amount. 10% of the outstanding is paid immediately, leaving £63,750 (=$76,500) outstanding.

At balance sheet date, (31.12.20X1) this payable would be re-stated at the closing rate £1 = $1.15 to £66,522, giving rise to an expense of (£66,522 - £63,750=) £2,772.

At 1st January 20X2 a payment of $42,500 would be made. As the exchange rate used was the rate which the balance had been converted, no exchange difference could arise. A debit of £36,957 would be entered, leaving a balance of £29,565 (=$34,000).

The final payment would be made on 1st February 20X2. The rate ruling was £ = $1.10 so the cost of settling $34,000 would be £30,909. £29,565 would be offset against the payable account and the remainder £1,344 would be an expense in the 20X2 income statement.

(b) Illinois Tools would record a sale and a receivable on 1st October 20X1 for (£70,000 X $1.25=) $87,500.

On 1st December it would receive £7,000 (=$8,400) in satisfaction of 10% of its outstanding debt ($8,750). The shortfall of $350 would be expensed in the 20X1 income statement.

At 31st December the closing rate was £1 = $1.15 so Illinois Tools' receivable of £63,000 should be restated to $72,450 from (87,500 - 8,750 =) 78,750 giving rise to a foreign exchange loss of $6,300.

The total charge to the income statement for 20X1 would be (350 + 6300 =) $6,650. The receivable in the statement of financial position at 31.12.20X1 was $72,450.

On 1st January Illinois should receive £35,000 (at £1 = $1.15 is $40,250) and this would be offset against the receivable, leaving a balance of $32,200 (= £28,000).

On 1st February Illinois would receive £28,000 which would count (£1 = $1.10) as $30,800. This would be credited to the receivable account, leaving a balance of $1,400 to be expensed as a foreign exchange loss in the 20X2 income statement.

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13.2 Solution - Continental Holdings – Primary FX translation

01.07.20X1 31.12.20X1 31.12.20X2 31.12.20X3 31.12.20X4 31.12.20X5 30.06.20X6

Statement of Financial Position

Statement of Profit or Loss

Value of Loan £'000

FX gain /(loss) £'000

5,000 4,705.9 4,878.0 5,714.3 6,153.8 5,555.5 4,878.0

294.1 (172.1) (836.3) (439.5) 598.3 677.5

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13.3 - Solution – Voltaire Industries SA – Secondary translation (1)

(a) Net investment method

Assets/Liabilities Leaseholds Acc. depreciation Plant Acc. depreciation Investment Inventories Receivables Cash ST Creditors LT Creditors Equity Ord. Shares Reserves Profit X1/X2 FX(1)

Candide £'000

Candide €'000

Voltaire €'000

Group €'000

3,000 (300) 10,000 (2,000)

4,500 (450) 15,000 (3,000)

319,500 (75,450) 865,000 (378,000)

1,750 2,500 2,500 (1,250) (5,000) 11,200

2,625 3,750 3,750 (1,875) (7,500) 16,800

315,000 (75,000) 850,000 (375,000) 17,000 85,000 120,000 163,000 (250,000) (100,000) 750,000 400,000 250,000 100,000

400,000 250,000 101,920 (2,120) 749,800

10,000 1,200 11,200 (1) FX = Translation adjustment as component of equity

17,000 1,920 (2,120) 16,800

750,000

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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87,625 123,750 166,750 (251,875) (107,500) 749,800

13.3 - Solution – Voltaire Industries SA (2)

(b) Temporal method:

Assets/Liabilities Leaseholds Acc. depreciation Plant Acc. depreciation Investment Inventories Receivables Cash ST Creditors LT Creditors Equity Ord. Shares Reserves Profit X1/X2 FX (2)

Candide

Candide (Sterling)

Voltaire (Translated)

Group

£'000

€'000

€'000

€'000

3,000 (300) 10,000 (2,000)

5,100 (510) 17,000 (3,400)

320,100 (75,510) 867,000 (378,400)

1,750 2,500 2,500 (1,250) (5,000) 11,200

2,712.5 3,750 3,750 (1,875) (7,500) 19,027.5

315,000 (75,000) 850,000 (375,000) 17,000 85,000 120,000 163,000 (250,000) (100,000) 750,000

10,000 1,200

17,000 1,690 (1) 337.5 19,027.5

11,200

400,000 250,000 100,000 750,000

Notes: 1. Profit before depreciation is: £'000 Profit for year Depreciation expense/ Leasehold Depreciation expense/ Plant Profit before depreciation =

1,200 300 2,000 3,500

Translation: Profit before depreciation Depreciation expense Profit for year 2.

3,500 X 1.6 2,300 X 1.7

5,600 3,910 1,690

FX = included in Group profit X1/X2

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

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87,712.5 123,750 166,750 (251,875) (107,500) 752,027.5 400,000 250,000 101,690 337.5 752,027.5

13.4 Solution - Flubdub Company – Secondary translation (1)

(a) Net investment method (cfr. IAS 21):

Yabber (LC)

Rate

Yabber (€)

2.0 2.0 2.0 2.0 2.0

1,120,000,000 80,000,000 600,000,000 600,000,000 400,000,000

Assets Property, plant & equipment (net) Non-current financial assets Inventories Trade receivables Cash and cash equivalents

560,000,000 40,000,000 300,000,000 300,000,000 200,000,000 1,400,000,000

Total

2,800,000,000

Equity and liabilities Share capital Reserves Profit for the year Translation adjustment (FX) Provisions Long-term liabilities - Flubdub Long-term liabilities - others Short-term liabilities Total

200,000,000 280,000,000 40,000,000 40,000,000 300,000,000 200,000,000 340,000,000

4.0 3.0 2.5

(1)

2.0 2.0 2.0 2.0

1,400,000,000

800,000,000 840,000,000 100,000,000 -700,000,000 80,000,000 600,000,000 400,000,000 680,000,000 2,800,000,000

(1) Primary translation adjustment from € 200 million to € 300 million (2) Separate item within equity

Revenue Raw materials and consumables used Staff costs Depreciation and amortisation expense Profit from operations Other expenses Profit for the year

Yabber (LC)

Rate

Yabber (€)

1,800,000,000 -600,000,000 1,200,000,000 -800,000,000 -80,000,000 320,000,000 -280,000,000 40,000,000

2.5 2.5

4,500,000,000 -1,500,000,000 3,000,000,000 -2,000,000,000 -200,000,000 800,000,000 -700,000,000 100,000,000

2.5 2.5 2.5

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13.4 Solution - Flubdub Company (2) (b) Temporal method: (i) With historical rate for depreciation expense:

Yabber (LC)

Rate

Yabber (€)

560,000,000 40,000,000 300,000,000 300,000,000 200,000,000

4 2 2.5 2 2

2,240,000,000 80,000,000 750,000,000 600,000,000 400,000,000

Assets Property, plant & equipment (net) Non-current financial assets Inventories Trade receivables Cash and cash equivalents Total

1,400,000,000

4,070,000,000

Equity and liabilities Share capital Reserves Profit for the year Provisions Long-term liabilities - Flubdub Long-term liabilities - others Short-term liabilities Total

200,000,000 280,000,000 40,000,000 40,000,000 300,000,000 200,000,000 340,000,000

4 3 2 2 2 2

1,400,000,000

Revenue Raw materials and consumables used Staff costs Depreciation and amortisation expense Profit from operations Other expenses Translation gain Profit for the year

800,000,000 840,000,000 670,000,000 80,000,000 600,000,000 400,000,000 680,000,000 4,070,000,000

Yabber (LC)

Rate

Yabber (€)

1,800,000,000 -600,000,000 1,200,000,000 -800,000,000 -80,000,000 320,000,000 -280,000,000 40,000,000

2.5 2.5

4,500,000,000 -1,500,000,000 3,000,000,000 -2,000,000,000 -320,000,000 680,000,000 -700,000,000 690,000,000 670,000,000

2.5 4.0 2.5

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13.4 Solution - Flubdub Company (3) (ii) Full average rate for revenue and expenses

Yabber (LC)

Rate

Yabber (€)

560,000,000 40,000,000 300,000,000 300,000,000 200,000,000

2 2.5 2 2

2,360,000,000 80,000,000 750,000,000 600,000,000 400,000,000

Assets Property, plant & equipment (net) Non-current financial assets Inventories Trade receivables Cash and cash equivalents Total

1,400,000,000

4,190,000,000

Equity and liabilities Share capital Reserves Profit for the year Provisions Long-term liabilities - Flubdub Long-term liabilities - others Short-term liabilities Total

200,000,000 280,000,000 40,000,000 40,000,000 300,000,000 200,000,000 340,000,000

4 3 2 2 2 2

1,400,000,000

Revenue Raw materials and consumables used Staff costs Depreciation and amortisation expense Profit from operations Other expenses Translation gain Profit for the year

800,000,000 840,000,000 790,000,000 80,000,000 600,000,000 400,000,000 680,000,000 4,190,000,000

Yabber (LC)

Rate

Yabber (€)

1,800,000,000 -600,000,000 1,200,000,000 -800,000,000 -80,000,000 320,000,000 -280,000,000 40,000,000

2.5 2.5

4,500,000,000 -1,500,000,000 3,000,000,000 -2,000,000,000 -200,000,000 800,000,000 -700,000,000 690,000,000 790,000,000

2.5 2.5 2.5

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14.1 Solution – Bruinzee NV - Provisions

(a) IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that if a provision is recognized for a single obligation, it should be measured at the most likely outcome. In this case the most likely outcome is that the case will be successfully defended, so in fact there is no obligation (provision) to be recognized for possible damages on reporting date, although the range of outcomes should be disclosed (contingent liability). Therefore, €1.8m should be removed from provision expenses.

As far as the legal costs are concerned, these will be payable to the lawyers irrespective of whether or not the case is successfully defended. The event giving rise to the legal claim, spurious or otherwise, has occurred before the year-end. Therefore, the full amount of the likely legal costs should be provided for and €100,000 added to provision expenses.

The issue of a potential reimbursement needs to be considered separately. IAS 37 states that an asset (and therefore a reduction in expenses) should only be recognized, if reimbursement is virtually certain. Therefore, Bruinzee NV is correct not to reflect this in the financial statements.

(b) Based on the facts presented now, it is more likely than not that an outflow of economic benefits will occur, so a provision is required.

Where a single obligation is being measured then IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that the individual most likely outcome is usually the most appropriate measure for the provision. The problem with using the expected value approach is that it produces a provision that would never represent the actual outflow of benefits.

The most likely outcome is a payment of €4m million so this is the amount that should be recognized.

A further charge of €1m is required to be made to provision expenses.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

14.2 Solution – Philippo Tist Corporation – Decommissioning costs

The €50 million cost of the site is debited to property, plant and equipment and depreciated over its 10-year useful economic life in accordance with IAS 16 Property, Plant and Equipment. The obligation to restore the site to its original condition must be recognized at 2 January 20X0. This is because, under the principles outlined in IAS 37 Provisions, Contingent Liabilities and Contingent Assets – the entity has a present obligation arising out of a past event that will entail a probable outflow of future economic benefits.

Where the effect is material, IAS 37 requires that the provision be discounted. This means that, at 2 January 20X0, the provision will be for €15 million x 0.463 = €6.945 million.

Where the future expenditure relates to the initial estimate of the cost of restoring an asset then IAS 16 requires that the debit entry for the creation of such a provision is to property, plant and equipment.

Therefore, the amounts relating to the asset in the financial statements for the year ended 31 December 20X0 are: a) Depreciation 1/10 x (€50 million + €6.945 million) = €5.6945 million. This will be presented as an operating expense. b) Property, plant and equipment 9/10 x €56.945 million = €51.2505 million. This will be presented as part of non-current assets. c) The provision needs to be increased over time as the discount unwinds. For the year ended 31 December 20X0: – The unwinding of the discount is 8% x €6.945 million = €0.556 million. This will be recognized as an interest expense.

– The closing provision is €6.945 million + €0.556 million = €7.501 million. This will be presented as a non-current liability.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

14.3 Solution – Omega- Non-current assets held for sale

Year ended 31 March 20X8 On 1 January 20X8, the property would be designated as „held for sale‟. The implications of this treatment are that the property would cease to be depreciated and be classified in a separate section of the statement of financial position – “non-current assets held for sale”.

The depreciation on the property to the date of classification as held for sale would be 150 (3,600 x 1/18 x 9/12) and this would be charged as an operating expense in the income statement. The carrying value of the property immediately before reclassification of 5,850 (6,000 – 150) would be compared with its „fair value less costs to sell’ of 7,020 (7,100 – 80). The new carrying value of the property is the lower of these two amounts – in this case 5,850.

Year ended 31 March 20X9 No depreciation will be charged on the property.

At the date of sale, the profit on sale of 1,150 (7,000 – 5,850) will be reported in the income statement.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

14.4 Solution – Power Company - Assets held for sale and Discontinued operations This assignment combines several issues (Assets held for sale, Impairment of a CGU with goodwill, Discontinued operations) and should be seen as an advanced assignment.

Comments are based on IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.

On 31 October 20X7, it appears that Theta will be regarded as a subsidiary that is held for sale. This is because its carrying value will be recovered principally through sale and a buyer is being actively sought.

From 31 October 20X7, the assets and liabilities of Theta will be separately presented on the consolidated statement of financial position at the lower of their current carrying values and their fair value less costs to sell. In this case this is €170 million.

No further depreciation of assets of Theta will be charged in the consolidated financial statements.

An impairment loss of €30 million (€200 million – €170 million) needs to be recognized and this is done in accordance with IAS 36 Impairment of Assets.

The impairment will be allocated to goodwill (see also Chapter 12 on this), which will have a new carrying value of €10 million (€40 million – €30 million).

Therefore €270 million (€260 million + €10 million) will be shown under assets held for sale and €100 million under liabilities directly associated with assets held for sale.

It would further appear that Theta would be regarded as a discontinued operation under IFRS 5.

This means that the line items in the statement of profit or loss would not include relevant amounts for Theta. What will be shown is any post-tax profit or loss for the period and the impairment of goodwill of €30 million.

More detailed disclosure of the results of Theta would be shown on the face of the statement of profit or loss or in the notes

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

15.1 Solution – Foldet SA – Deferred taxes

Depreciable amount of the equipment = €1,400,000 - €200,000 = €1,200,000 Depreciation for tax purposes

Depreciation for reporting purposes

Temporary differences

20X1 20X2 20X3

450,000 350,000 250,000

300,000 300,000 300,000

150,000 50,000 (50,000)

20X4

150,000

300,000

(150,000)

The temporary difference in 20X1 is a taxable temporary difference that will result in taxable amounts in determining taxable profit of future periods, so it brings us to recognize a deferred tax liability and a deferred tax expense.

Deferred taxation of temporary differences over the useful life of the equipment:

Accumulated temporary differences

Deferred tax liability (at 20% tax rate) in the balance sheet

Effect on the Statement of profit or loss

20X1

150,000

30,000

20X2

200,000

40,000

20X3

150,000

30,000

20X4

0

0

30,000 deferred tax expense 10,000 deferred tax expense 10,000 deferred tax income 30,000 deferred tax income

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

15.2 Solution – Deftax – Deferred taxes Assumptions - Item of heavy machinery: cost 20, 000; 4-year useful life; straight-line depreciation over 4 years ▪ Tax depreciation (per year): 8,000 – 6,000 – 4,0000 – 2,000 Corporate income tax rate = 30% Deferred tax liability and expense in year 1 - 4 (Start 20X1)

20X1

Year 20X2

20X3

12,000

6,000

6 2,000

0

20X4

Balance sheet, end year Non-current asset (heavy machinery) Tax value

20,000

Carrying amount

20,000

15,000

1,000

5,000

0

Deductible (taxable) temporary difference

0

(3,000)

(4,000)

(3,000)

Deferred tax asset/(liability)

0

(900)

(1,200)

(900)

(0) 0

-900

-300

+300

+900

20X10 15,000 -5,000 10,000

Year 20X2 15,000 -5,000 10,000

20X3 1,500 -5,000 0000 05 10,000

20X4 15,000 -5,000 10,000

Current tax expense* Deferred tax expense (see above)

-2,100 -900 -3,000

-2,700 -300 -3,000

-3,300 +300 -3,000

-3,900 +900 -3,000

Net profit

7,000

7,000

7,000

7,000

15,000

15,000

15,000

15,000

-8,000 7,000 2,100

-6,000 9,000 2,700

-4,000 -2,000 1,000 1 13,000 3,300 3,900

Statement of profit or loss for year Deferred tax expense (-) [Deferred tax income (expense reversal) (+)]

Assumptions ▪ Profit before machinery depreciation is 15,000 each year ▪ Accounting depreciation 5,000/year (for four years) ▪ Tax depreciation (per year): 8,000 - 6,000 – 4,000 – 2,000

Income tax rate 30% Published accounts: Summary P/L statements

Profit before machinery depreciation Accounting depreciation on machinery

*According to company's tax return: Profit before machinery depreciation Tax depreciation on machinery Taxable profit Tax currently payable (at 30%) (= current tax expense)

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

15.3 Solution – T-Haven – Deferred taxes (1)

a) Depreciation scheme and determination of temporary differences

Tax/ Statutory

IFRS Standards TF

20X1

20X2

20X3

20X4

20X5

Net book value Depreciation exp..

2,000 (200)

1800 (200)

1600 (200)

1400 (200)

1200 (200)

NBV STAT (*)

1800

1600

1400

1200

1000

Net book value Depreciation exp.

NNBVBV IFRS NBV IFRS Standards

2000 (100) 1900 1900

1900 (100) 1800 1800

1800 (100) 1700 1700

1700 (100) 1600 1600

1600 (100) 1500 1500

100

200

300

400

500

34

68

102

136

170

Temporary difference (NBV Stat-NBV IFRS) @ Tax rate 34% = Deferred tax liability

b) Simplified Statement of Profit or Loss for Year 20X1

Statutory/Tax Profit before depreciation

IFRS Standards

500

500

- Depreciation of equipment

(200)

(100)

Profit before tax (= Taxable profit) - Current tax expense (@ 34%) - Deferred tax expense

300 (102)

400 (102) (34)

= Profit after tax Effective tax rate*

198 34%

264 34%

*Effective tax rate = Total tax expense (Current +/- Deferred) / Profit before tax

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

15.3 Solution – T-Haven – Deferred taxes (2)

Accounting entries: 1.

2.

3.

4.

20X1 - Current tax Dt Current tax expense (- E) @ Ct Current tax liability (+ L) - Deferred tax Dt Deferred tax expense (- E) @ Ct Deferred tax liability (+ L) 20X2 -Current tax Dt Current tax expense (- E) @ Ct Current tax liability (+ L) -Deferred tax Dt Deferred tax expense (- E) @ Ct Deferred tax liability (+ L) 20X5 – YTD situation deferred taxes Dt Deferred tax expense (- E) @ Ct Deferred tax liability (+ L)

102 102 34 34

102 102 34 34 170 170

20X6 - Sale of equipment for €1600 Calculation of gain on disposal Statutory/Tax NBV Sales price Gain

1000 1600 600

-IFRS Standards accounting entry: Dt Deferred tax liability (- L) @ Ct Deferred tax income (+ E)

IFRS Standards 1500 1600 100

170

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

170

15.3 Solution – T-Haven – Deferred taxes (2)

c) Simplified Statement of Profit or Loss for Year 20X6

Statutory/Tax Profit before sale of equipment + Gain on disposal Profit before tax (= Taxable profit) - Current tax @ 34% - Reversal of deferred tax liability (= Deferred tax income) Net tax expense Profit after tax Effective tax rate

1,000 600

IFRS Standards 1000 100

1,600 (544)

1,100 (544) 170

(544) 1,056 34%

(374) 726 34%

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.1 Solution – Cleaney Inc (1)

Some ratios:

20X8

20X7

20X6

20X5

20X4

Earnings per share (EPS) Dividend per share Dividend cover Return on equity Return on capital employed Return on assets Gross operating margin Net operating margin Net profit margin

1.16 0.23 5.00 4.89% 8.62% 6.93% 23.96% 7.32% 1.47%

0.97 0.00 NA 4.30% 7.36% 6.12% 23.52% 6.56% 1.29%

3.68 0.74 5.00 16.42% 11.31% 9.89% 23.70% 10.80% 5.48%

2.80 0.56 5.00 14.53% 17.05% 14.19% 24.82% 12.65% 6.88%

3.18 0.00 NA 22.65% 18.38% 13.58% 24.53% 12.42% 6.41%

LT Debt/Equity ratio Total Debt/Equity ratio Gearing (total debt) Interest cover

182.68% 251.58% 71.56% 0.40

196.11% 256.08% 71.92% 0.39

186.39% 227.68% 69.48% 2.63

56.76% 88.36% 46.91% 3.48

138.78% 223.09% 69.05% 2.81

Current ratio Acid test

0.76 0.66

0.78 0.54

1.02 0.81

1.21 0.98

0.83 0.74

Total asset turnover Inventory turnover (days)

0.95 10.28

0.93 20.71

0.91 13.54

1.12 17.30

1.09 11.27

Credit given (days) Credit obtained (days)

18.43 42.26

20.77 53.48

17.68 54.64

19.28 58.30

9.07 102.14

EBITDA

31,123

26,912

30,840

15,320

10,580

Sustainable growth

3.91%

4.30%

13.14%

11.63%

22.65%

Effective tax rate

30.00%

30.00%

30.00%

30.00%

30.00%

24.06%

22.95%

22.28%

22.87%

22.45%

23.70% 29.35% 23.54%

25.29% 27.48% 22.35%

28.97% 27.57% 21.36%

39.74% 35.68% 38.49%

47.10% 32.99% 56.99%

Segment information Laundry gross profit margin Reprographics gross profit margin Laundry ROA before overhead Reprogr. ROA before overhead

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.1 Solution – Cleaney Inc (2) Analysis of Cleaney’s investment and financing policy: ●During the past few years, Cleaney experienced considerable growth in terms of both sales and total assets. ●This growth had a negative impact on the firm's profitability. ROA, for example, has more or less been halved over the period 20X4-20X8. ●ROA as the product of `Total Asset Turnover' and `Net Operating Margin' - it can be seen that both factors deteriorated. The significant decline in `Total Asset Turnover' for 20X6 shows that the significant capital expenditures of 20X6 yield an unsatisfactory increase in sales. ●The `Gross Operating Margin' is more or less stable over the period under study. Coupled with the considerable decrease in the `Net Operating Margin' (cf. supra), this finding suggests that distribution and administration costs have grown out of proportion. The increase in distribution expenses might (i.e. at least partially) be explained by advertising campaigns that are needed in order to launch new products (i.e. the self-produced reprographics equipment). ●Cleaney's financing policy seems to lack consistency. In 20X5, Cleaney issued 700,000 new shares.

Based on the information contained in the statement of financial position, the share issue yielded $14,700,000. It looks like about one third of this amount has been used to repay long-term debt.

However, during the following year (i.e. 20X6), Cleaney contracted new loans in order to finance additional capital expenditures. The fact that Cleaney had to resort to new borrowings only one year after the share issue, suggests that Cleaney's management lacks a longer-term vision. ●The structure of the statement of financial position clearly reflects the increased indebtedness.

Considering the solvency ratios, it goes without saying that Cleaney's financing structure is precarious. ● The relation between ROE and ROA also shows that Cleaney does not succeed in an efficient use of its large amount of debt. ● In addition, Cleaney made considerable additional investments during both 20X7 and 20X8. As a result, the relatively strong operating cash flow for both years did not suffice to cover the total amount of capital expenditures, interest charges, taxes and dividends. From the balance sheets, it can be seen that Cleaney sought solace in short-term loans. This solution clearly had a negative impact on the firm's liquidity position (the amount of current liabilities exceeding the amount of current assets). ●The segment data show that both the Laundry and the Reprographics department experienced considerable growth in sales as from 20X4. Nevertheless, in terms of profitability (gross operating margin and ROA before overhead), the financial condition of the Reprographics department deteriorated gradually, while the profitability of the Laundry department remained stable. The observation that things got worse for the Reprographics department as of 20X5, brings us to speculate that the investments for 20X6 were made in an attempt to resolve these problems. To date, these capital expenditures have clearly not yet paid off.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.1 Solution – Cleaney Inc (3) Recommendations ●In short, Cleaney can be described as a firm experiencing a significant increase in sales over the last few years (probably partly due to acquisitions - see the increase in the amount of intangible assets (goodwill?)), while not being able to convert this growth in increased profitability. Accordingly, the large amount of capital expenditures caused a precarious situation in terms of both liquidity and solvency. ●Both issues (liquidity and solvency) require urgent action. If they are not dealt with in the short term, they might threaten Cleaney's going concern. So, a search for additional equity is a logical move. In order to ensure that the additional share capital is not just a drop in the ocean, the amount has to be significant, probably resulting in a considerable dilution for the current shareholders' stake in the company (control and/or equity per share). Before an investment in Cleaney is made, one has to ascertain that existing shareholders agree with such a strategy. If so, the additional capital will improve the firm's liquidity and solvency position. ●An investment in Cleaney requires additional steps in order to safeguard the firm's liquidity and in order to free additional liquidity. A first step might be the revision of Cleaney's dividend policy. As of 20X5, 20% of net profits are distributed to shareholders. Considering the liquidity needs of the firm, it would clearly make more sense to retain all profits. A second step might be the replacement of expensive short-term loans by some cheaper means of external financing (e.g. trade credit). The negative relationship between days of credit received from suppliers and solvency suggests that creditors have become more stringent in response to Cleaney's solvency problems. An improvement of the firm's solvency position might therefore relax the terms of credit with its suppliers.

●It should be clear that if DW decides to invest in Cleaney, the investment should yield an adequate return. The investment should therefore not only improve the firm's solvency and liquidity position, but also its profitability. As mentioned earlier, distribution and administration expenses have grown out of proportion. Accordingly, these expenses have to be scrutinized in an attempt to cut them down.

Outsourcing some activities could be an option. Moreover, potential restructuring projects should be identified. It might also be interesting to re-examine Cleaney's earlier investment decisions. That is, it might be worthwhile to consider divestments in certain domains. This could free liquidities and enhance Cleaney's liquidity and solvency position and reduce the additional amount of capital required by the firm. Based on the limited segment information we have at our disposal, the profitability of the Reprographics department is certainly in need of further scrutiny - a review of the inhouse production activities. Of course, it might be that the decrease in profitability of the Reprographics department is not firm-specific, but rather an issue for the entire industry.

Nevertheless, the timing of the capital expenditures and the observed profitability pattern suggest a firm-specific link.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.2 Solution– Gloucester Gardens plc (1)

Some ratios: 20X5 1,500/3,369.5 45%

20X6 2,000/3,724.7 54%

20X7 3,000/4,124.2 73%

20X8 3,382/6,069.1 56%

20X9 3,383/6,799.7 50%

Current ratio

746.7/394.1 1,89

1,012/555.8 1,82

1,259.6/730.2 1,73

1,581.6/1,272.2 1,24

2,020.4/1,581.6 1,28

EPS (pence)

17,0

23,9

27,8

30,1

38,4

Dividend per share

4,17

5,56

7,78

7,92

10,00

Substainable growth

9.1*(1-(75/306)) 6,9

11.5*(1-(100/430)) 8,9

12.1*(1-(140/499)) 8,7

11.9*(1-(190/722)) 8,8

13.5*(1-(240/921) 10,0

Gross oper. margin

875.3/2,220 39,4%

1,174.5/2,941.3 39,9%

1,432.8/3,537.8 40,5%

1,875.6/4,573 41,0%

2,321.5/5,584 41,6%

Net oper. margin

514.3/2,220 23,2%

776.5/2,941.3 26,4%

981.8/3,537.8 27,8%

1,378.6/4,573 30,1%

1,767.5/5,584 31,7%

Net profit margin

306.2/2,220 13,8%

430.1/2,941.3 14,6%

499.5/3,537.8 14,1%

720.9/4,573 15,8%

920.6/5,584 16,5%

Total asset turnover

0,42

0,46

0,45

0,43

0,48

ROA (EBIT/Tot.assets)

9,8%

12,4%

12,5%

13,1%

15,3%

ROA (incl. tax-effect)

(306.2+(83*(10.29)))/5,263.6 6,9%

(430.1+(146*(10.32)))/6,280.5 8,4%

(499.5+(232.3*(10.33))/7,854.4 8,3%

(720.9+(269*(10.35)))/10,541.3 8,5%

(920.6+(332.6*(10.36)))/11,581.3 9,8%

703,5

996,5

1262,5

1774,7

2178

306.2/3,369.5 9,1%

430.1/3,724.7 11,5%

499.5/4,124.2 12,1%

720.9/6,069.1 11,9%

920.6/6,799.7 13,5%

(306.2+(83*(10.29)))/4,869.5 7,5%

(430.1+(146*(10.32)))/5,724.7 9,2%

(499.5+(232.3*(10.33))/7,124.2 9,2%

(720.9+(269*(10.35)))/9,269.1 9,7%

(920.6+(332.6*(10.36)))/9,999.7 11,3%

0,29

0,32

0,33

0,35

0,36

83/1,500 5,5%

146/2000 7,3%

232.3/3,000 7,7%

269/(3,200+182.2) 8,0%

332.6/(3,200+182.8) 9,8%

Debt/ equity

EBITDA Return on equity

ROCE

Effective tax rate Cost of debt

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.2 Solution– Gloucester Gardens plc (2)

In headlines terms, our assessment is: - company performing very well in terms of ROE, ROCE; - rapid and successful expansion programme; - but major financing requirement; - strategy of maintaining both nursery and retail division needs analysis, given higher returns in retail side; - business needs "big brother" to re-finance and provide better controls but is operating very successfully in niche.

Just to amplify aspects of that: •

It looks as though the company has no real long-term financing plan. Expansion has been financed until 20X8 by internally generated equity and by borrowing (debt/equity moving from 45% in 20X5 to 73% in 20X7). Although the growth rate is good (7% in 20X5 rising to 10.4% in 20X9), it was certainly not high enough to maintain the debt/equity ratio. The company has paid out a rising dividend consistently through this period, although it appears generally to have been fairly short of cash because of its continued expansion. Figures suggest the company ran into borrowing problems in 20X8 and was persuaded by its bankers to take in outside equity. It cannot continue to expand without adjusting its debt/equity to a slightly more comfortable level. It could do this just by not expanding for a year or two - its strong cash flows would quickly reduce borrowing - or by finding a bigger partner.

•

The relationship between nursery and retail divisions should be examined (note: since all nursery sales are to retail, the sales figures for retail division are what appear in the published accounts as total sales - the internal sales would cancel against cost of sales in retail division), it could be argued that there are really two businesses here. In headline terms, taking 20X5, the retail side achieved a gross margin of 29.5% (assuming, as the question states, that purchases from nursery division are at market prices). Using the book value of retail premises as a crude measure of investment, this was 34.9% return on investment (before overheads). At the same time nursery division made a margin of 20%, giving a return of 8.5% on investment in premises.

Retail division have consistently improved margins, from 29.5% in 20X5 to 35.5% in 20X9.

On the face of it, there is no financial logic in buying further nursery premises in 20X8. The nursery division does not yield an adequate return and the company was already fully extended.

One could speculate that the bank may have pointed this out, causing GG to look for an equity partner at that time.

The relationship between nursery and retail therefore needs examination. Further discussion would have to answer the questions as to whether (i) the transfer price from nursery to retail is really market price; (ii) if so, whether the inventory coming from the nurseries has some special quality which is critical to the success of the retail side, such as offering unique products which bring in customers who then also buy other high margin goods from retail? (iii) whether there is any reason why GG cannot buy the inventory in the marketplace and release the cash tied up in nursery assets? (for example, is it the daughter who is keen on the nursery side and could that be sold off to her?).

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.3 Solution – Who is who (1)

Ratio set A B C D E F G H

Company (2) (3) (7) (5) (8) (4) (6) (1)

Company Name BASF SODEXO RANDSTAD REGUS ASOS DOMINO’S PIZZA LOUIS VUITTON MH TESCO

Ratio data refer to the period 2012-2014

Suggested sequence of analysis: 1) Credit given is short (E, F, H) when customers are expected to pay cash. This is a valid assumption for the supermarket chain (1), the internet clothing retailer (8) and the pizza restaurant chain (4). a. The pizza restaurant chain has a high inventory turnover (inventory is used within less than one week): F = 4. b. The internet clothing retailer has a much higher gross operating margin and higher average inventory than the supermarket chain, while its tangible infrastructure is much less extensive than that of the supermarket chain (fixed asset turnover): E = 8, H = 1.

2) The inventory turnover is NA when there is no material inventory (probably valid for the real estate company and the employment agency). The real estate company owns office buildings that it rents out, making it much more capital intensive than the employment agency. This results in a lower fixed asset turnover for the real estate company: C = 7, D = 5.

3) The producer and distributer of luxury products needs a high gross operating margin to compensate low inventory turnover. It also has high selling overhead (see difference between gross and net operating margin) and many sales outlets in expensive neighbourhoods (fixed asset turnover): G = 6.

4) A and B are left over for companies (2) and (3). Major differences = inventory level, inventory turnover and fixed asset turnover. The catering company provides food services, an activity expected to result in a high inventory turnover and a relatively low average inventory level: B = 3. The chemical products manufacturer (2) is probably very capital intensive (extensive production facilities) and is thus likely to have a lower fixed asset turnover. This corresponds with A. Final solution for columns: 2 -3- 7- 5- 8 – 4 -6 – 1

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning

17.3 Solution – Who is who (2)

Additional notes: - First let students look for ratios with the larger differences between companies (credit given, inventory level and inventory turnover) and let them reason about the underlying business.

- Compare current ratio and acid test ratio to get a hint of the magnitude of the inventory level of the company.

- Inventory turnover „NA‟ (Not Applicable) may mean no inventory or no sales; compare current ratio and acid test ratio to figure out the relevance of inventory.

- Fixed asset turnover is an indicator of the capital intensity of the company.

- Inventory (level and turnover) and capital intensity are useful to distinguish between the manufacturer of chemical products and the provider of catering services.

- Return on assets and net operating margin are less useful in solving this assignment.

For use with Global Financial Accounting and Reporting: Principles and Analysis, 5e

by Walter Aerts and Peter Walton (9781473767126) © 2020 Cengage Learning